TCS Daily

The Dividend Fiasco

By Kevin Hassett - May 9, 2003 12:00 AM

Washington insiders are currently being treated to one of the oddest spectacles in recent memory. The White House is campaigning actively against a large tax reduction favored by House Republicans, deriding it as aggressively as they might a marginal tax rate hike.

Here is the background for the story. As mentioned in this space last month, Ways and Means Committee Chairman Bill Thomas crafted a dividend tax reduction that has about the same economic effect as the President's proposal, but significantly reduces its complexity. (For reasons that escape me, the thing even is scored at a much lower cost than the President's plan.) The Thomas bill enjoys tremendous support among House Republicans. Accordingly, one might expect that the White House would declare victory, ally itself with the House, and try to force things in the Senate. The opposite has occurred.

Instead of working with the House, the administration is currently supporting a bizarre variation of its original proposal that is gaining steam in the Senate. Under their favored plan, dividend tax rates are reduced steadily over three years to zero, and then reinstated. This phase-in and phase-out has the attraction that it costs significantly less money, and thus can (theoretically) make it past Sen. Olympia Snowe, the reluctant tax cutter.

Think, for a moment, of the likely wacky effects of such a plan. If a firm pays you a dividend next year as opposed to this year, then you will save 33 percent on your taxes. With rates falling so sharply, it would be positively irresponsible for a firm to pay any dividends at all until the rates are at their lowest. Then, in 2005, the rate is zero for only one year. Thus, a firm will have an incentive to pay dividends that it might have planned to pay in 2006 in 2005 as well. So under the administration's proposal, dividends would go as close to zero as firms could manage for a few years, spike to their highest level in history, then drop sharply for some time.

Now one might wonder about the importance of all of these financial shenanigans, but a basic logical problem presents itself. While selling the original plan, supporters emphasized the beneficial effects of increased dividend payouts. Administration sources admit that dividends will likely decline relative to today under this plan between now and 2005. How can that be a harmless event given that increases in dividend payments are viewed to be so wonderful? Clearly, this proposal is one of the most patently absurd tax policies ever proposed.

With dividend tax rates dancing like fairies for the next few years, firms will have difficulties setting dividends and shareholders will have even more difficulties figuring out what current dividends signal about future prospects. Since the elimination of dividend taxes is only temporary, investors must evaluate the risk that dividend taxes will come back. If they do, then the cash flows to investors from owning stock will plummet, as will the value of shares. Under such circumstances, it is undeniable that government policy significantly increases the fundamental risk of stocks. It would be hard to imagine that this would be good for the stock market or the economy.

Clearly, the administration's favored approach has one and only one attraction. In one year, the tax rate makes it all the way to zero, and hence political operatives can craft speeches about the end of the double tax of dividends. Recall, however, that even this zero is not really a zero tax rate. The personal tax on dividends is lowered, but the President's complicated plan offsets this by devaluing other tax benefits at the corporate level. If the tax were zero every year, the President's plan would be a bit more stimulative than the Thomas proposal. But zero in one year is not even close.

There are certainly sound arguments to be made that the President's original proposal is superior to that crafted by Bill Thomas. I disagree with those in the administration who would claim that there is a big difference, but the argument can be made. One could not possibly argue, however, that the current approach taken by the White House in the Senate has superior economic merit. Let's hope they wake up and smell the economics before it is too late to save dividend tax reduction.

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