Diving into the Dividend Fray, Pondering Perverse Effects

Everybody knew a plan to cut the corporate dividend tax was on its way. Buttotal elimination? Back in early December, TheStreet.com reported that the “scuttlebutt” was a (in retrospect) humble exemption-the first $5,000 to $50,000 of dividends-and, as late as the current issue of Business Week , forecasts were for a proposal that would cut the tax in half. But then the President threw us all a Laffer curve. “[He] looked at the economy,” wrote a triumphal John Podhoretz in the New York Post , “looked at his choices, looked at his opponents-and chose to go all-out.”

Depending on who you ask, going “all-out”-i.e., the wholesale exemption of dividends from federal taxation-is a stimulus package, an unconscionable sop to the rich or elegant tax-code reform. (My favorite contribution to this dialogue: According to Internet gold bug Adam Hamilton, the plan undoes the work of “liberal socialist thieves who have slithered into the Halls of Power in the United States like a plague of fiery serpents.”) The slithery left is plaguing us, all right-with statistic after galling statistic meant to display how much the tax cut skews to the wealthy. “Two hundred and twenty thousand American taxpayers,” Columbia economist Joseph Stiglitz told the PBS NewsHour , “will get the same amount as 120 million people at the bottom.”

The supply-sider comeback? They’re too busy rejoicing to bother. The tax agitators on the trickle-down right have lived to see their dream President; they’re tanned, fit and ready for a close-up. “We are going to cripple the entire Democratic leadership all at once,” Grover Norquist, beside himself over the dividend plan, crowed to a New Republic reporter. “The Bush dividend tax cut will be the biggest event to hit the asset markets since the 1981 Reagan tax cuts,” Larry Kudlow, chief talking head of the self-styled “pro-growth” right, promised the New York Post.

But the refrain in the financial press has been: Be careful what you wish for . In a sharply argued Heard on the Street column, Ken Brown pointed out that investors can be mindlessly trendy-and just as they demanded growth in the 90′s, they “now believe that cash in the form of a dividend check is more valuable than a promise of future riches.” Holding companies to a fixed schedule of cash payouts may discipline scheming managers, but it may also handcuff the good ones. The clamor for dividends effectively deprives companies of the more flexible option of the buyback-a de facto dividend that raises per-share earnings. I.B.M. used this tactic cunningly throughout the 90′s, Mr. Brown points out, tacking back and forth between retaining earnings one year and rewarding shareholders the next. But once a dividend is in place, forget it: “companies are loath to cut [them].” Besides, adds former hedge-fund manager Andy Kessler, dividends- feh . “Dividends entice investors into debt-laden, slow- or no-growth companies,” he wrote in a feisty Journal op-ed : “Who would we rather the stock market provide investment capital to, someone working on hydrogen fuel cells or dividend-paying electric utilities milking 30-year-old soot-belching power plants?”

What about the old classic, that the cut would end “double taxation” of dividends? In the left corner, Paul Krugman, idol of the bien pensant : “[L]ots of income faces double taxation …. [M]ost of us pay income and payroll taxes when we earn our salary, then pay sales taxes when we spend it.” In the right corner, the Journal ‘s honorary Bushie, Holman Jenkins Jr., who believes the tax should be abolished at the corporate level: “Then it wouldn’t [be] a tax cut that benefits taxpayers according to their tax bracket but one that puts equity squarely on the same footing as debt.” Everyone, of course, agrees with The Financial Times ‘ donnish murmur, that “tax policy should be neutral. [It] should not distort behaviour by encouraging companies and consumers to favour one action over another.” Because capital gains are taxed at a lower rate than dividends, companies have been encouraged to grow at all cost, behavior that may have contributed to the market bubble; and as interest payments are deductible, the tax code encourages debt over equity financing. But be careful what you wish for . “Neutrality” argues just as convincingly for raising the capital-gains tax to parity with ordinary income, or ending the deduction for interest payments. And to engineer a more truly neutral dividend tax cut, the administration would have to make it hopelessly complex.

Enter the unflappable Floyd Norris of The New York Times , who explained, “The most striking new addition to the pantheon of corporate finance … would be the ‘deemed dividend.’” Effectively, retained earnings would now automatically be considered a “deemed” (or unpaid) dividend, thus raising the cost basis of shares and reducing any future capital gain should the shares be sold. Barron ‘s Alan Abelson drove home the point: “There’s something paradoxical, even comical, about the administration’s vowing to simplify the tax code even while it pushes what bids to be easily among the most complicated tax plans ever devised by the human mind.”

But why be so pointy-headed? The idea behind the tax cut is simple enough. “See,” explained the President, “by ending double taxation of dividends, we will increase the return on investing, which will draw more money into the markets to provide capital to build factories, to buy equipment, hire more people.” Ah, be careful what you wish for . The legacy of Nasdaq 5,000 was capital overhang and an overleveraged consumer. The dividend tax cut, argues Stephen Roach, chief economist at Morgan Stanley, is like refilling the punch bowl to avoid a hangover: The administration is resorting to “the same recipe that got America in trouble in the first place-hyping the stock market and the bubble-induced excesses it prompted in the real economy.”

Which brings us back to Mr. Kudlow. Only two years ago, he assured The American Spectator that a “bandwidth revolution will come and the Internet will take over economic life,” bringing in its wake Nasdaq 10,000. Now Mr. Kudlow has bet the house on what he terms a “new investor class” in America. As an editorial in The Economist from the 2000 election cycle explained, Mr. Kudlow has popularized the idea of a shareholder society, and that the doubling of the number of Americans owning mutual funds “could be one of the biggest social, as well as electoral, changes in America.” After weeks of pounding the table on the CNBC show he shares with James Cramer, Mr. Kudlow has received much of the credit for shaping the President’s thinking on dividend tax relief. Be careful what you wish for! Come the next election, the guy in Muncie with his odd-lot stake in the newly dividend-yielding Oracle may fancy himself a member of the new investor class. Or he may just think of himself as unemployed.