Dividends’ Role Gains Currency

President Bush’s proposal to eliminate taxes on cash dividends that companies pay shareholders has the potential to return investing to a simpler time -- a stock market familiar to octogenarians, perhaps, but foreign to most baby boomers.

If Bush’s idea becomes law, millions of individual investors would have a powerful incentive to consider buying stocks as much for the income they pay as for long-term capital gains. That concept was well known for much of the last century, but for many investors it disappeared entirely by the 1990s.

Now, after three years of falling share prices, more Americans may be keenly interested in the idea of demanding a regular check from companies in return for risking capital in the firms. And the Bush plan could all but assure that those checks would be more substantial, money managers and other experts say.

The repercussions in the financial world could be far-reaching -- and for many people could upend years of careful investment planning.

One consequence could be to effectively undo the appeal of holding dividend-paying stocks or mutual funds in tax-sheltered retirement accounts such as 401(k) plans -- which until now had been standard advice. Earnings of those accounts are subject to tax when withdrawn, which would cancel any dividend tax exemption.

Ending taxation of dividends also could mean that stocks would become tougher competition for Treasury bonds and municipal bonds, forcing bond issuers to pay higher yields on those popular securities.

For companies, the proposal could dramatically change how they structure their finances. To raise money, issuing certain types of new stock could become more appealing than borrowing. And pressure almost certainly would grow on all firms to increase the share of profits they pay to shareholders via dividends. That could limit earnings that are left to fund expansion.

“This could mean a sea change in how companies look at their dividend policies,” said Allan Rudnick, a principal at Kayne Anderson Rudnick Investment Management in Los Angeles.

Indeed, cash-rich technology leaders such as networking firm Cisco Systems Inc. and software giant Oracle Corp., which have never paid any of their profits to shareholders through dividends, would have to reconsider under the Bush plan, Rudnick said.

Jeff Henley, Oracle’s chief financial officer, told investors at a conference Tuesday that the end of dividend taxes “would have a significant impact on our thought process” about cash payments to investors.

Dividend payments by those firms could mean a more level corporate playing field. Old-line firms such as DuPont Co., Eastman Kodak Co. and General Electric Co., which have long paid dividends, might be viewed more favorably relative to technology firms. And the old-line companies would be expected to raise their dividends further.

For investors, “the reeducation process will be massive,” said Robert Willens, a tax expert at brokerage Lehman Bros. in New York.

The concept of the dividend is as old as that of shareholder ownership of companies. In theory, at least, all profits generated by a company belong to its owners. The company’s directors and managers, however, decide what to do with those profits: reinvest them in the business, buy other businesses or give them to shareholders.

For most of the 20th century, dividend payments were a crucial element of the long-term “total return” on stocks, which refers to the combination of capital gains and dividend income. Many investors came to rely on the quarterly cash checks their companies issued.

From 1926 to 1993, blue-chip stocks produced an average return of about 10% a year for investors, according to data tracker Ibbotson Associates. Of that total, 5.4% a year was from capital appreciation and 4.9% was from dividends.

But by the 1980s, dividend income began to fade in importance as the tax rate on long-term capital gains was cut while dividends remained taxed as ordinary income (such as wages).

In 1997 the capital gains tax rate was cut again, to a maximum of 20%. That coincided with and helped fuel that era’s surge of money into the stock market from individual investors. But with the top tax rate on dividend income nearly twice the capital gains tax rate, there was little reason for many investors to want dividends -- and thus little incentive for many firms to pay or raise dividends.

With the bull market’s collapse since March 2000, however, millions of investors have learned the brutal lesson that stock capital gains can quickly evaporate.

Even before the Bush administration began to talk about eliminating taxes on dividends, more investors in recent years had regained an appreciation for dependable dividend income. Many high-dividend stocks have led the market since 2000.

Politically, the idea of cutting dividend taxes has long stemmed from the argument that dividends are doubly taxed: Companies pay taxes on their net earnings, then shareholders are taxed on dividends paid out of those earnings.

The Bush administration believes that the elimination of dividend taxes would help the stock market recover and thereby boost consumer and business confidence, in turn lifting the economy.

Since the Bush proposal began to be widely discussed last week, the stock market has, in fact, rallied. The Dow Jones industrial average gained 4.8% in the first four trading days of the new year, despite slipping 32.98 points to 8,740.59 on Tuesday.

How much of a lift the market might ultimately get from a dividend tax cut is widely debated. Many analysts are dubious that Congress would go along with elimination of dividend taxes. But even a partial tax cut could reinforce the appeal of dividend-paying stocks in an era of more cautious investing, experts say.

For older individual investors who already rely at least in part on dividends to pay living expenses, a tax cut would instantly mean more spending power.

For younger investors who may not need current income but are looking for higher returns on their savings over time, a dividend tax cut could boost the appeal of stocks compared with, say, Treasury bonds. The same might apply to institutional investors.

Ten-year Treasury notes, for example, now pay an annualized yield of 4.01%. That interest is subject to regular tax rates.

By contrast, chemical titan DuPont pays an annual dividend of $1.40 a share. Based on the firm’s stock price of $44.58 on Tuesday, the dividend works out to a 3.1% annual yield. For someone in the top 38.6% federal tax bracket, if that 3.1% yield were tax-free it would be equivalent to a taxable yield of 5.05%.

Moreover, bond interest payments stay set for the bond’s life. A dividend, by contrast, is expected to increase as a business grows and its earnings rise.

A change in dividends’ tax status is likely to spur the brokerage industry to embark on a huge sales campaign touting dividend-paying stocks.

“It’s fantastic for brokers,” said Lehman’s Willens. “Now they have something to sell.”

Meanwhile, many individual investors are likely to need help sorting out their investment strategies -- for example, reshuffling assets in retirement accounts, probably to emphasize bonds while making new purchases of dividend-paying stocks through taxable accounts.

But financial advisors warn investors against making wholesale portfolio changes, noting that the Bush plan faces months of debate in Congress.

Advisors also warn that whatever the allure of dividends, investors must remember that stocks are inherently risky. Fallen companies such as Enron Corp. once paid dividends. That was no guarantee of the companies’ long-term success.

“I wouldn’t want to fool an investor into thinking that stocks are now magically safer,” said Brent Kessel, a financial planner at Abacus Wealth Management in Pacific Palisades.