Benefits of tax cut on dividends debated

By Wendy Tanaka
Knight Ridder News Service

The centerpiece of President Bush's sweeping economic stimulus package is a reduction in the taxes investors pay on their stock dividends, a measure aimed at making stocks attractive again.

But experts are divided on whether that will encourage corporations to increase or start making dividend payments.

Donald Straszheim, a financial advisor in Los Angeles, believes the change will have a positive impact. "It's going to greatly encourage investors to favor dividend-paying stocks," said Straszheim, founder and principal of the research firm Straszheim Global Advisors Inc.

Dividends are corporate earnings paid to shareholders, usually quarterly as cash or stock. Currently, investors who hold stock in taxable accounts must pay income tax on dividends at rates from 10 percent to 38.6 percent. Under the new tax law, the top tax rate is 15 percent through the end of 2008.

In recent years, many investors have shied away from dividend-paying stocks, preferring returns that come mainly from gains in stock prices. No taxes are paid on such gains until a stock is sold at a profit. The tax is then levied at the capital-gains rate, capped at 20 percent — well below what most investors pay on dividends.

Dividend yields, computed as a company's most recent annual dividend payment divided by its current stock price, have been declining. The yields on Standard & Poor's 500 index stocks peaked at 6 percent on average in 1982, and were as low as 1.12 percent in 2000. For the 12-month period ended March 31, the average dividend yield was 1.91 percent.

Straszheim says the new tax cut "materially changes the after-tax expected rate of return for investors. Corporate managements will know that, and they will react to it."

Other experts were not convinced. Mark Zandi, chief economist at the research company Economy.com Inc. of West Chester, Pa., said the cut would not precipitate meaningful change.

"Looking back five years from now, companies will pay more in dividends, but it won't be that significant. There won't be a groundswell in the way companies treat dividends and manage their finances. It still makes more sense to finance through debt capital and compensate shareholders through capital gains than dividends."

Zandi noted that under the tax law changes, investors still pay less in capital-gains taxes, because the bill lowers the top capital-gains tax rate from 20 percent to 15 percent. That could cancel out the benefits of the dividend tax cut, making dividends less attractive, he said.

Zandi also noted that the dividend tax cut lasts only five years, "although the general view is that Congress will continue to renew it.

"Senior managers are loath to change financial management, given the uncertainty," he said.