Who'd have thought that smack dab in the middle of Against the Grain's first ever, much-anticipated two-part series on federal tax plans, President Bush would sack his economic team? A coincidence? I don't think so.
For the record, Against the Grain is one of the very few venues that defended Paul O'Neill. I liked O'Neill. I liked his no-b.s. pronouncements, his gaffes, his tin ear for politics and his trip to Africa with Bono. I liked Larry Lindsey, too.
And I liked their dislike of the way the tax code treats corporate dividends. Supposedly, some kind of repair for that problem was to be included in the administration's economic "growth" plan.
While they shuffle the deck, White House spin dealers say that the new faces don't mean new policies, just new sales pitches. So I guess that some cut in the taxes on dividends might still be in the cards.
That would be a good thing.
Any stimulus (or growth) package that passes next year is going to be "show business," in the candid words of the late, great St. Paul of Alcoa. They'll mix two tablespoons of investors' breaks with one teaspoon of cuts for the middle class, and add a sprinkle of something for the poor on top. Then, if the economy happens to swing back, Washington will take the credit.
But adding a well-designed reduction in the taxation of dividends to the recipe might create some lasting good, whatever happens with the economy in the short run.
Here's the disservice the tax code perpetrates on dividends: a business' net profits are taxed at the corporate rate and then, when the business distributes some of those profits to shareholders as dividends, they are taxed again as personal income to the shareholder.
This is taxing the same money twice and it's not fair.
Fixing the unfairness, though, is not the main virtue here. Reform would allow the market to allocate capital more efficiently. It would stop government penalization of dividend-paying stocks and dividend-stock investors. Most importantly, it could help eradicate some of the accounting flim-flam that has scandalized corporate America this year.
The corporate dividend, once the security blanket of Main Street investors, has become almost extinct. In the 1980's and early 1990's, the average dividend yield on stocks in the S&P 500 varied between 5 percent and 6 percent. For the past five years, that dividend yield has been below 2 percent. In the boom years, dividends seemed like sops for suckers.
This happened greatly because the tax code punishes dividends.
On the business end, it works this way: businesses can raise capital two ways, by issuing stock or borrowing money. Interest payments are deductible to corporations; dividend payments are not. So companies have a tax-based incentive to borrow money rather than issue stock.
On the individual side, dividends are taxed at regular income rates while capital gains are taxed at lower rates; $1,000 in dividend income is taxed more than $1,000 in capital gains. That gives investors a tax-based incentive to prefer capital gains to dividends.
Now here is where corporate crime comes in.
The trend away from dividends coincided neatly with the self-interest of corporate managers who were increasingly rewarded with stock options. Just as the tax code discourages dividends, it encourages stock options; grants of stock options to company execs are tax deductible (so they reduce the company's tax bill), but they do not have to be listed as expenses (so they increase the company's earnings on paper).
Now, stock options increase in value only when the stock price goes up. Managers who have stock options have magnified incentive to boost their company's stock prices. Shareholders seeking capital gains, not dividend income, make money only when prices rise.
With stocks that don't pay dividends, prices go up when the firm's earnings go up, are forecast to go up or investors bet they will go up. So stock prices are greatly determined by how good the company's books look. Because of they own stock options, corporate managers have had greater incentive than ever to cook the books, as this year on Wall Street amply demonstrated.
Earnings are numbers on computers screens; shareholders can't buy things with earnings. Accounting ledgers can be manipulated; dividend checks can't be, they either come in the mail or they don't. If they come, and the checks clear, investors really could care less if a company's earnings statements are doctored.
According to Alan Greenspan, when dividend yields were higher, "one of the problems we did not have… is earnings manipulation."
Eliminating the tax penalties for dividends does not mean forcing companies to pay dividends; it is simply treating debt and equity, dividend income and capital gains income equally.
Growing companies can often create more value for shareholders by reinvesting their profits than by paying dividends. They will continue to do so and the market will judge them. For example, shareholders in Cisco Systems, which is sitting on some $21 billion in cash that could be distributed as dividends, recently voted not to do that.
There are two ways to fix this. Either companies should be allowed to deduct dividends, or individuals should receive an exclusion or preferential rates for dividend income. The latter is easier to sell politically.
Democrats have traditionally fought both solutions. You know the sound byte, "These are tax cuts for the rich."
Well, a lot of non-rich people have 401(k)s and mutual funds now. Even if they don't have dividend income, or if it's tax exempt in their retirement accounts, they have an interest in more honest big businesses. Candidate John Kerry picked up on this and he's now a liberal Democrat who favors cutting taxes on dividends.
Many Democrats assume that voters still believe they are the party that protects the little guy's wallet. The 2000 and 2002 elections should have cured them of that notion.
Dick Meyer, a veteran political and investigative producer for CBS News, is Editorial Director of CBSNews.com based in Washington.
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