Monday Morning: Dividend taxes give pause for thought

President Bush created a hot topic for discussion when he proposed ending the double taxation of dividends by making dividends received by investors exempt from income taxes.

Obviously, tax exemption of dividends would be a boon for individual investors, particularly those on fixed incomes.

At present, those investing for income must calculate whether they are better off investing in stocks and selling regularly to realize any appreciation, investing in taxable bonds and taxable dividend-paying stocks for income and paying taxes on those transactions, or investing in tax-exempt municipal bonds.

The problem for those investing in stocks hoping to realize appreciation is the possibility of severe bear markets: Selling stocks for the income when the market is down can crimp retirement savings.

The sticky issue for those investing in bonds is that, with the exception of those who invest in Treasury inflation-protected securities, they barely keep pace with the rate of inflation.

Dividend-paying stocks give investors a chance to keep up with inflation, but yields are often low, and those low yields are then taxed as ordinary income.

Eliminate the taxes, and dividend-paying stocks become more attractive to investors. They have an income stream likely to grow enough to keep up with inflation, and a chance of appreciation in the stock prices.

Obviously, if dividends become tax exempt, many mutual funds will restructure their portfolios to take advantage of the change. These are likely to be funds with low levels of 401(k) and individual retirement account assets because those assets are already tax exempt.

And the reordering of investment opportunities will be a challenge for financial advisers. They will have to get up to speed quickly on the details and implications of any new tax treatment of dividends.

Furthermore, both existing and new clients are likely to come in for guidance about how they can best deal with the changes, given their unique financial situations.

Those are some of the micro issues inherent in Mr. Bush’s plan. But there are macro issues as well.

Would it be good for the economy if more companies paid dividends, and if those paying dividends paid more?

Or would it be better for companies to continue to retain the earnings to reinvest in themselves or to buy other companies?

When I was getting my master’s degree in business administration in 1970-71, my finance professor said it was generally better for companies to retain earnings than to pay dividends.

He said that was because most companies had better investment opportunities than did individual investors, and retained earnings were the cheapest source of financing. Thus a company should pay out dividends only if it couldn’t see high-return opportunities in its own businesses.

Interestingly, the dividend payout ratio of companies in the Standard & Poor’s 500 stock index began to fall from more than 60% in 1970-71 to about 40% now and was as high as 60% for only brief spells in the interim.

Recent research and empirical experiences have disproved my professor’s stance.

A paper by Rob Arnott of First Quadrant LP, a money management firm in Pasadena, Calif., and Clifford Asness of AQR Capital Management LLC in New York says companies with high payout ratios have had higher real earnings growth than companies with low payout ratios (i.e., high retained earnings). The report will be published in a forthcoming issue of the Financial Analysts Journal.

The study confirms anecdotal evidence from the 1990s which suggested that companies waste too much of their retained earnings on poor investments. The individual investor receiving the earnings as dividends could hardly have done a worse job allocating them to other investments than most corporate managements have done.

In short, dividend payments serve as a brake on corporate management’s profligate tendencies.

Furthermore, other research suggests that dividends serve the same purpose as do the colors of a peacock’s tail: They signal good health.

In the case of corporations, dividend payments signal that management is confident of a company’s continued fiscal health.

So at both the macro and micro levels, dividends do matter.

And if nothing else, President Bush’s proposal has brought a discussion of their significance out of academic circles and into the real world.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.