Tax policy has always been a favorite government tool to try to change behavior -- of consumers, investors, companies and the government itself.
The tax-cut bill that Congress sent to President Bush on Friday has the potential to modify the behavior of all of those constituencies, perhaps in significant fashion over time.
There is little question about the bill's anticipated effects on consumers and government. The former are expected to spend more, and the latter is virtually certain to borrow more.
For investors and companies, however, the changes the bill may bring seem less obvious, partly because it is unclear exactly what Congress was trying to do with that part of the tax law.
When President Bush first proposed tax changes in January, the idea was to end federal taxation of company dividends entirely. The plan was presented as an issue of basic fairness, addressing the perennial Republican pet peeve of "double taxation": Companies pay tax on their gross profit, then shareholders pay tax on dividends paid out of net profit.
Bush also said the plan for a zero tax rate on dividends received by investors was about boosting the stock market and stoking job creation, but many economists saw it principally as a major tax-reform measure. "What does this have to do with fiscal stimulus?" William Dudley, an economist at brokerage Goldman Sachs & Co. in New York, asked at the time.
When Congress took up the debate over Bush's proposal, the House was willing to go along but some senators deemed as too expensive the cost to the Treasury of permanently eliminating dividend taxes. So a compromise had to be struck to get a bill to Bush.
The result is that investors now will face a maximum 15% tax rate on dividend income and on long-term capital gains, down from 38.6% and 20%, respectively. The 15% rate -- good for at least five years -- is the lowest investors have paid on either dividends or capital gains since before World War II.
Any tax on dividends received means that some form of double-taxation still exists. Thus, the tax reform that Bush initially sought is only partly achieved by what Congress sent him.
Nonetheless, investors have been given a gift in the form of lower tax rates on both dividends and capital gains.
So what behavior does the government now expect of investors? Simply put, it must expect them to take more risk.
In theory, the sharp decline in investment tax rates should make investors feel less reluctant to put fresh cash into the stock market. If that happens, it could make more capital available to companies, which could boost the economy -- depending, that is, on how corporate managers would put that capital to work.
Lower tax rates on dividends and capital gains "will have a profoundly positive effect on job creation," Treasury Secretary John Snow said Thursday in his official statement about the legislation.
The stock market has staged a strong rally over the last two months, lifting the blue-chip Standard & Poor's 500 index 16.5% and the Nasdaq composite index 18.8% since March 11, though they both declined modestly last week.
For the wobbly economy to strengthen in the second half of the year, many Wall Street pros believe it's crucial that share prices continue to advance, because that should help lift consumer and business confidence.
Yet millions of investors remain skittish about stocks after the losses they suffered over the last three years, and given the corporate and brokerage scandals that have been all too prevalent.
"What you really need is to get people interested in the stock market again -- get people to take risks again" with their money, said Dan Laufenberg, chief economist at American Express Financial Corp. in Minneapolis.
Robert Morris, chief investment officer at mutual fund firm Lord Abbett & Co. in Jersey City, N.J., put it more bluntly: "The stock market is where investors have to overcome their fear and loathing."
Reducing the Risk
By cutting tax rates, the government is lessening some of the risk involved in betting on stocks. If you bet correctly, your reward will be higher than it would have been without the tax changes.
Combined with the monetary policy of the Federal Reserve -- which already has slashed short-term interest rates and yields on high-quality bonds to their lowest levels in a generation -- the Bush administration is sending investors a message that it could never say out loud, but which goes something like this:
"If you want to earn anything more than paltry returns on your savings, you must forget about money market funds and Treasury bonds and consider buying stocks."
That message is almost certainly falling on fewer deaf ears than it would have, say, a year ago.
"Investors' impatience is growing with the lack of return on [capital] parked in cash," said Liz Ann Sonders, chief investment strategist at brokerage Charles Schwab Corp. in New York.
No wonder: In the last two months, major stock indexes often produced in one day the average 0.7% return investors in money market mutual funds now can expect to earn in one year.
But it's a dangerous business for the government to strongly encourage Americans to take more risk with their savings. If the three-year-long bear market isn't over, and stock prices take another turn for the worse, no investment tax rate cut will be of much help.
As originally proposed, the Bush tax-reform plan would at least have encouraged investors to focus on what typically are viewed as lower-risk, less volatile shares: those that pay substantial cash dividends.
By eliminating the tax on dividends, the government would have intensified the spotlight on generous-dividend stocks. Since the bear market began in 2000, many investors already have come to appreciate what a regular cash dividend payment can mean.
"Capital gains are theoretical," said Joseph Lisanti, editor of Standard & Poor's Outlook investment newsletter in New York. A dividend payment, by contrast, is real money in an investor's pocket every quarter, he noted.
Because the tax rate reduction on dividend income is more substantial than the reduction in the capital gains rate, it would seem that dividend-paying stocks still should enjoy a bigger benefit from the tax bill than companies that don't pay dividends.
Yet if that's the case, the companies that would attract more attention -- and capital -- would tend to be larger, established firms that generally aren't the businesses creating huge numbers of new jobs.
Indeed, on Friday, with the tax bill a done deal, some investors hungrily snapped up electric utility stocks, which tend to sport some of the highest dividend yields in large part because the businesses aren't viewed as fast growers.
That's one of the basic truths of generous dividends: Investors always have expected a company to pay out more of its earnings in the form of dividends when the firm's long-term growth prospects (and thus its stock capital-gain potential) is below-average.
Demand for Dividends
With the tax rate on dividend income and capital gains now equalized, Wall Street is expecting that investors could demand higher cash dividend payments from companies across the board.
Why not, as S&P;'s Lisanti put it, favor a bird in the hand (a dividend) rather than two in the bush (a potential capital gain)?
But is that the kind of corporate behavioral change Congress and the Bush administration intended to encourage?
Treasury's Snow alluded to that idea in his statement on the tax bill last week, when he said the changes would have a positive effect on "corporate accountability."
Many companies turned away from increasing their dividends in the late 1990s. They argued that the high tax rate on those payouts meant it made more sense to use retained earnings to buy back stock on the open market, with the hope of giving shareholders a bigger capital gain.
As the bull market raged, most shareholders were happy to buy into that approach.
Conveniently, by trying to drive up their stock prices, corporate managers also rewarded themselves, because so much of their compensation came in the form of stock options.
As it turned out, plenty of retained earnings were grossly wasted on mergers and other corporate transactions that, in retrospect, were terrible decisions. It would have been better if much of those earnings had been given to shareholders via dividends, allowing them to decide where the capital should be directed.
Even with the drop in tax rates, however, it is far from certain that enough investors will petition corporate managers for higher dividends. And managers' natural inclination may well be to retain as much of profit as they can, in the name of financing their companies' long-term growth.
Big institutional investors such as pension funds are tax exempt, so the dividend tax rate doesn't matter to them anyway, in principle.
Likewise, many individual investors hold their stocks in tax-deferred retirement accounts. Will they care about higher dividends?
Numbers Not Promising
Many market analysts believe the dividend worm has in fact turned. They see cash payouts forthcoming from more companies that have never paid dividends (in the technology industry, for example), and higher dividends from companies that already pay them.
"I think one measure of good management will be how a company increases its dividend," said Carl Domino, chairman of Northern Trust Value Investors in Bowdown Beach, Fla.
Yet so far this year, the numbers aren't encouraging: A total of 586 companies have raised dividends this year through April 30, up just 2.3% from the number in the same period of 2002, according to S&P.;
With dividend and capital gains tax rates the same, some corporate managers could take the view that shareholders still might prefer a bigger capital gain over time. A dividend is a taxable event each quarter; a capital gain is a taxable event only when the investor chooses to sell.
Laufenberg worries that some corporate managers may decide against paying higher dividends because, with the tax cut, their shareholders are in effect earning a higher dividend without an actual increase in the payout.
For now, this is all conjecture and theory. From the standpoint of Congress and the White House, it may be enough if investors buy stocks again -- any stocks -- if that helps to ensure the economy stays in recovery mode.
If corporate behavior with shareholders' profit is going to become more responsible, that will primarily be up to the shareholders themselves to decide, not the government.
In the long run, that's probably a good thing.
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Average yields, by stock sectors
Here are average dividend yields, by industry sector, for stocks in the blue chip Standard & Poor's 500 index, the mid-cap S&P; 400 and the small-cap S&P; 600. The data show the highest yielding stocks generally are in the utility, basic materials and financial services sectors.
*--* S&P; S&P; mid-cap small-cap S&P; 500 400 600 Consumer discretionary 1.0% 0.4% 0.6% Consumer staples 2.0 1.0 0.9 Energy 2.6 0.4 0.2 Financials 2.3 2.5 2.6 Health care 1.6 0.2 0.2 Industrials 2.0 0.9 0.9 Information technology 0.4 0.1 0.1 Materials 2.7 2.3 1.2 Telecommunication services 3.4 0.8 0.0 Utilities 3.9 4.4 3.8 Overall index 1.8 1.2 1.0
Data as of May 21.
Source: Standard & Poor's
Tom Petruno can be reached at firstname.lastname@example.org. For recent columns on the Web, go to: www.latimes.com/ petruno.