TCS Daily

Incentives Matter: A Lesson

By Daniel Clifton - July 23, 2004 12:00 AM

On Tuesday, Microsoft Corp. announced the company will double its annual dividend payment to shareholders by $3.5 billion per year, pay a one-time special dividend of $32 billion and repurchase $30 billion of company stock over the next four years. The special dividend payment is the largest in S&P 500 history and quickly turns Microsoft from a small dividend payer to the tenth highest on the S&P 500 Index.

Wall Street had long expected Microsoft to revise its corporate payout policy due to the company resolving legal issues and holding cash reserves totaling more than $56 billion. However, Wall Street was caught off guard by the substantial amount of cash reserved for dividend payouts relative to repurchasing stock.

Goldman Sachs analyst Rick Sherlund told CBSMarketwatch, "The announcement was big and bold, as we had expected, but we had expected the mix to reflect more share repurchase and less special cash distribution."

The reason for the unexpected distribution of dividend cash is the result of the changing incentives contained within President Bush's Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) signed into law last May. The legislation significantly reduced the double tax on dividends, and then equalized the capital gains tax rate with the dividend tax rate. The effect of the tax cut was more than just a lower tax burden for investors; the changes altered the incentives for corporate payout policies resulting in higher dividend payments than previously was the case.

First, lowering the double tax made dividend issuance more efficient for companies leading to higher dividend payouts. Just as important, however, the equalization of capital gains tax rates and dividend rates for the first time has led to companies pursuing a more efficient allocation of stock repurchases and dividend payouts. As a result, companies are now making investments based on the economic value of their choices and not the tax consequences; and shareholders are reaping enormous benefits, as evidenced by Microsoft's announcement on Tuesday.

Prior to the signing of the tax cut, dividends were taxed once as part of corporate earnings at a 35 percent rate, and again as the personal income of the investor at a top rate of 39.6 percent, resulting in an effective tax rate of more than 61 percent. The exorbitantly high rate of double taxation was a major factor in the 20 year decline of companies paying a dividend. The number of S&P 500 companies paying a dividend dropped from 469 companies in 1980 to 351 in 2002.

The tax cut reduced the double tax on individual shareholders to a 15 percent rate and immediately corporations increased their existing dividends and new companies began initiating first time dividends. In July 2003, 179 companies increased their dividends; that's the most since 1979. By the end of 2003, 19 more companies listed on the S&P 500 were paying dividends than in 2002 and another eight S&P 500 companies have initiated a dividend this year. If this trend holds up it will be the first time in 15 years the number of companies paying a dividend on the S&P 500 has increased two consecutive years.

But more importantly, the equalizing of the capital gains tax rate with the dividend tax rate readjusted corporate payout policies based on the economic value of a decision, not the tax consequences. The capital gains tax rate of 20 percent was much lower than the dividend tax rate of 39.6 percent. Companies in turn disproportionately favored generating capital gains through stock repurchases rather than dividends due to tax considerations.

The new change in tax law left the capital gains and dividend tax rates at 15 percent making corporate decisions neutral in regard to the tax benefits. Resources are now being allocated more efficiently. This has resulted in more dividend payments relative to share repurchases.

More dividend payments translate into real benefits for shareholders. Real personal dividend income increased 5.8 percent in 2003, by far exceeding the 4.5 percent annual average since 1990. According to S&P, net individual dividend income increased by 50 percent in 2003 from $32.7 billion to $49.1 billion.

Microsoft's action significantly built upon this momentum. The one-time special dividend payment, which equates to roughly $3 per Microsoft share, will return approximately $9 billion to individual Microsoft shareholders. As such, Microsoft's payout alone will increase total individual shareholder dividend payments of S&P 500 companies by 18 percent this year.

The unleashing of Microsoft's cash also provides a two-fold benefit to corporate governance, further benefiting shareholders. Lower amounts of cash reserves will force managers to undertake only the most productive internal investments. Moreover, the enhanced regular quarterly dividend can only be paid out of earnings that actually exist, which promotes honest accounting practices.

Democratic presidential candidate Sen. John Kerry used the latter point to push for abolishing the double taxation of dividends during a speech in December 2002. Kerry told the Cleveland Economic Club, "And we should encourage the measurement of the real value of companies by ending the double taxation of dividends." President Bush followed one month later with a proposal to abolish the double tax but Kerry reversed course, quickly denouncing the proposal as a give away to the rich for partisan purposes. Kerry then proceeded to vote against the legislation at least 7 times in 2003.

Clearly, Kerry was for eliminating the double taxation before he voted against it, as was the case with his decision on funding American troops in Iraq and Afghanistan.

Fortunately, Kerry's vote was not needed to pass the legislation at the time and all American shareholders are better are off because of it. Yet Kerry has made repeal of this provision a central part of this campaign because he is missing the same point that Wall Street analysts missed: incentives matter. Kerry's shortsighted proposal to remove the incentives for companies to return cash to their owners will undoubtedly harm shareholders. Not only will investors face a higher tax burden every April 15th, shareholders will have far less dividend income and, as Kerry put it, the "measurement of the real value of companies" will be compromised.

Daniel Clifton is the executive director of American Shareholders Association. He can be reached at


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