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A dividend tax cut would
raise the after-tax return on dividend paying assets above that
on all other assets. The resulting thermal disequilibrium would
lead investors to rebalance portfolios, driving dividend paying
asset prices up relative to other assets. The Intrinsic Value of
the S&P 900 would rise by 5.1% at a 20% tax rate, and 8.5% at
a 0% tax rate, increasing net worth by $481 billion, or $799 billion,
respectively. Differential effects vary widely by sector. There
are huge potential further gains for companies that increase payout
ratios and reduce debt. 
The Bush dividend tax cut will be the biggest event to hit the asset
markets since the 1981 Reagan tax cuts. It will have a huge impact on
asset prices, interest rates, growth, and the dollar. It will create
a host of opportunities for investors to make money. It will also create
a wave of restructuring, recapitalization, and acquisition events among
US companies.
Conceptually, a dividend tax cut would impact stock prices in two
phases. Initially, it would work by raising the after-tax return on
dividend paying assets above that on all other assets. The resulting
thermal disequilibrium, characterized by an unsustainable gap between
after-tax returns, would lead investors to individually attempt to rebalance
their portfolios, selling non dividend paying assets to buy dividend
paying assets.
Collectively, these attempts would drive the prices of dividend paying
assets up relative to all other assets, which would reduce the after-tax
return gap until returns were driven back in line. These price changes
would increase the market value of equities, as well as the net worth
of investors.
A reduction of the dividend tax rate from 38.6% to 20%, for example,
would increase the Intrinsic Value of the S&P 900 by 5.1% and increase
investors’ net worth by $481 billion.
A reduction of the dividend tax rate from 38.6% to 0% would increase
the Intrinsic Value of the S&P 900 by 8.5% and increase investors’
net worth by $799 billion.
Effects vary widely by sector, as shown below in Chart 1; the biggest
effects will occur in sectors with high dividend payout ratios and no
debt. In the Telecommunications sector, for example, the reduction to
a 20% dividend tax rate would increase equity value by 20.1%; the reduction
to a 0% dividend tax rate would increase equity value by 33.4%.
Chart 1
Stock Price Impact of a 20% Dividend Tax Rate
These initial effects will be followed by a second round of potentially
larger stock price increases as managers alter company strategies to
take advantage of the new tax regime. One-time special dividends to
distribute excess cash, increased payout ratios, and issuing new shares
to reduce debt will all increase value. These opportunities, which are
concentrated in sectors with low payout ratios, like Information Technology,
could be huge. Raising the dividend payout ratio in the Information
Technology sector to 100%, for example, would increase equity values
by 42.1% in the case of a 0% dividend tax rate.
Dividends are currently taxed twice, once at the corporate level,
then again at the investor level, which makes it hard to get a dollar
of profit into an investor’s pocket. Consider, as an illustration,
XYZ Corporation. At current tax rates XYZ has to earn $2.51 in pretax
profits to put $1.00 of dividends in its shareholders’ pockets.
Out of the $2.51 of pretax profits it pays $0.88 (35% of pretax profits)
in corporate income taxes to the IRS, leaving $1.63 in after-tax profits.
If it pays that $1.63 to investors as a dividend, the investor who receives
the dividend pays an additional $0.63 (38.6% of dividend income at the
top marginal rate) to the IRS, leaving exactly $1.00 in his pocket.
Double taxation makes dividends an extremely leaky and inefficient bucket
for carrying profits from the corporation to the investor. Overall,
$1.51 (60%) of XYZ’s original $2.51 has gone to pay taxes; only
$1.00 (40%) found its way to the investor. In comparison, both interest
payments and capital gains are more efficient channels for paying profits
to investors. It would cost XYZ only $1.63 in interest payments to put
a dollar of after-tax income in investors’ pockets, since interest
is deducted as an expense at the corporate level. Better still, XYZ
could put the same after-tax dollar in investors’ pockets by delivering
only $1.25 in the form of capital gains—tax free to the corporation;
20% tax rate to the individual—by reinvesting profits to generate
growth or by “investing” its after-tax profits in stock
buybacks.
Not surprisingly, corporate managers have figured this out; paying dividends
has gone out of style. Only 20.8% of public companies paid dividends
in 1999, down from 66.5% as recently as 1978. Those that do pay dividends
are paying out a lower share of profits or using stock buybacks in their
place.
Double-taxation of dividend income has given rise to serious inefficiencies
in capital markets. It has diverted capital away from business ventures
that produce reliable, large, and growing free cash flow streams for
their owners in favor of companies that produce no profit but offer
a hope of future capital gain. This distortion of managerial incentives
was a material contributor to the excesses of the stock market boom
in the late 1990s and to the severity of the subsequent correction.
It also created the presumption in the minds of many managers that they
should avoid paying profits to investors, which contributed to the governance
scandals that were exposed by declining equity values in the past few
years.
Cutting the dividend tax rate at the investor level to zero would promote
more efficient use of capital among competing uses by removing the existing
distortion among the after-tax returns that guide investor behavior.
Here’s how it would work.
The way to understand the dividend tax cut is to focus on the economy’s
capital accounts by analyzing the effects of changes in the dividend
tax rate on relative asset demands, therefore on asset prices and investment
spending. This framework has its roots in the laws of thermodynamics—the
most trusted principle in physics, chemistry, and biology.
Here’s how it will work. Start with the example of a zero-growth
company XYZ, discussed above, that has no debt and pays out 100% of
its after-tax profits as dividends. Last year, the company paid shareholders
a dividend of $1.63 per share. Shareholders paid 38.6% (their marginal
income tax rate) of the dividend, or $0.63, to the IRS and put the remaining
$1.00 in their pockets. XYZ’s stock price is $20 per share. Shareholders
earned a 5% after-tax return on their investment—$1.00/$20.00—which
is exactly equal to the after-tax return on all other assets.
In thermodynamics, if you put a hot object and a cold object into contact,
heat will flow from the hot to the cold object until they reach thermal
equilibrium where there is no temperature difference. You can try this
yourself by placing a steaming hot dog and an icy cold can of soda into
your child’s lunch pail in the morning and ask them to report
what they find when they open it to eat lunch. (Your child may learn
some physics. Even better, they may start making their own lunch.)
If you put two objects together that are the same temperature, however,
nothing will happen. Physicists call this situation thermal equilibrium.
This principle works in asset markets just as well as in lunch pails;
only in economics we call it arbitrage and we refer to thermal equilibrium
as portfolio balance. Unlike heat, however, money runs uphill, from
low after-tax return to high after-tax return investments. Just like
in physics, asset markets reach thermal equilibrium when after-tax returns
are equal.
Our XYZ company example, above, is in thermal equilibrium because all
assets have the same 5% after-tax return. There is no opportunity for
investors to improve their net worth position by trading one asset for
another. Regardless of what they own, they will earn 5% after-tax.
The dividend tax cut changes all that. Assume the government passes
a law that makes XYZ dividends tax-free. (A good lobbyist will do that.)
The company still pays the same dividend to the investor, but now the
investor gets to pocket the entire $1.63.
Now the investor earns $1.63/20.00 = 8.15% on his investment after taxes.
This is far better than the 5% investors are earning on other investments.
This metaphorical temperature differential means that asset markets
are no longer in thermal equilibrium. An investor can improve his position
be selling one of his 5% assets and using the proceeds to buy XYZ stock.
As all investors try to do so—they all have the same information—they
will run into a traffic jam. They will all try to sell 5% assets to
people who are trying to do the same thing, and will all try to buy
XYZ stock from people who are also trying to buy XYZ shares. In this
situation, we know one thing for sure; the price of XYZ shares will
go up.
How much? If the market capitalization of XYZ is small compared with
the market, so we can ignore the effects on other asset prices, the
price of XYZ will rise until after tax returns are again equal and thermal
equilibrium has been reestablished. This will happen when the price
of XYZ has risen to $32.60, at which price its owners will earn an after-tax
return of $1.63/$32.60 = 5% on their capital.
Where did the extra value come from? It is the present value of the
cash flow stream that has been diverted from the IRS to investors.
Cutting the dividend tax rate from 38.6% to zero has increased the Intrinsic
Value of XYZ stock from $20 to $32.60, an increase of 63%, which equals
the ratio of (1 – old tax rate) and (1 – new tax rate).
Analytically, we can describe this as a decline in XYZ’s cost
of equity capital, the return it must pay investors to remain competitive
with other uses for their capital. A decline in the cost of capital
increases equity values as a multiple of current after-tax profits.
The mechanism through which a reduction in the dividend tax rate from
the current maximum rate of 38.6% to 20% increases equity values is
shown in Table 1. The logic applies in exactly the same way to the case
of reducing the dividend tax rate to 0%, which is shown in Table 2.
Table 1 shows that a reduction in the tax rate on dividend income from
the current maximum rate of 38.6% to 20% would reduce the cost of equity
capital—the return a company must pay investors to attract equity
capital—for the companies represented in the S&P 900 by 90
basis points (0.9%), from 7.2% today to 6.3%. The reduction in the cost
of equity capital varies from 200 basis points for Telecommunications
companies to 20 basis points for Information Technology companies, since
the former pay out essentially all earnings as dividends while the latter
pay essentially no dividends. (I have used data on payout ratios for
2001, the last full year of data available from Compustat, to make the
calculations. In a rigorous valuation we would use, instead, estimates
of expected payout ratios over the life of the investment, which would
change the reported numbers in Table 1 and Table 2 somewhat.)
Lower cost of equity translates into lower cost of overall capital to
the extent a company’s capital structure is made up of equity,
rather than debt. (The Equity Capital Ratio data measures equity capital
(including both common and preferred equity) as a percent of total capital.
The decrease in cost of capital varies from 10 basis points for the
Information Technology sector to 100 basis points for the Telecommunications
sector, and equals 20 basis points for the broad market as represented
by the S&P 900.
A lower cost of capital increases the Intrinsic Value of a company’s
equity—the present value of future free cash flow less debt—by
reducing the discount rate used to estimate present values. As in the
case of bonds and real estate securities, the impact of a 100 basis
point reduction in cost of capital on Intrinsic Value will depend on
the shape of the expected future cash flow stream.
The Intrinsic Values of companies with front-loaded cash flow streams—those
for which the bulk of free cash flow occurs in the early years—would
be relatively insensitive to changes in the cost of capital. The technical
term for this is short duration, the time-weighted average maturity
of future cash flows. Those with back-loaded cash flow streams—high-growth
companies with negative cash flow in the early years—will be strongly
impacted by a reduction in the cost of capital. These are securities
with long durations.
Our estimates of the sensitivity of Intrinsic Value per 100 basis point
reductions in the cost of capital—21.2% for the S&P 900—is
shown in Table 1 for the overall market as well as its ten component
sectors. The column labeled Stock Price Impact shows estimates of the
impact of the dividend tax cut on the Intrinsic Value of the S&P
900 and its component sectors, taking all these factors into account.
Although overall stock prices should increase by just over 5%, the sectoral
impacts vary widely, from roughly 3%, for the Information Technology
and Technology sectors, to 20% for the Telecommunications sector.
These stock price increases will increase market capitalization and
investors’ net worth by $481 billion, with increases concentrated
in Industrials ($135B), Consumer Discretionary ($121B), Telecommunications
($79B), and Health Care ($65B).
This is only the beginning. Astute managers will soon learn that companies
that take advantage of the new, lower, tax rates will have lower capital
costs and become tougher competitors than others. Over time, they will
adapt their business practices to the new tax regime. The irony is that
the sectors, industries, and companies that will initially benefit most
from the lower dividend tax rate will have the least flexibility to
improve their value, while those that initially benefit the least have
the most to gain by changing behavior.
Many technology companies, for example, like Microsoft, have strong
cash profits and large cash balances, but pay no dividend. They will
have enormous latitude to increase their share prices by introducing
a dividend and paying large special dividends out of current cash balances.
Other companies that are principally debt-financed will benefit very
little initially, but have broad scope to increase value by selling
shares to reduce debt.
Shareholders will exert pressure on managers to increase dividend
payouts and deleverage their businesses. Managers who own stock or stock
options will gladly agree to do so. They will increase payout ratios
out of current profits and sell new stock to finance growth. And, they
will sell new stock to repay debt. Both will increase stock prices.
The upward limit of the resulting rise in stock prices ranges between
50% and 60% for different sectors. This could add 5% or more per year
to total returns for several years as companies adjusted to new tax
rates.
Preferred stocks, with high dividend yields, 100% payout ratios, and
implicit 100% equity financing, represent the most efficient way to
place a bet on the initial gains on dividend paying stocks. Straight
preferred stock could take on many of the characteristics of debt. Convertible
preferred stock issued by companies with low common stock payout ratios
(therefore, big upside from strategy change) are also attractive.
Common stock of companies or industries with big dividend payout ratios
(Verizon, SBC, BMY, IDU) are also attractive ways to benefit from the
initial price increase. The subsequent gains will accrue to companies
or industries with flexibility to increase payout rates, pay meaningful
special dividends, or refinance capital structure (MSFT, CSCO, INTC,
and SUNW).
Watch out for a head fake with Real Estate Investment Trusts (REITs)
and Master Limited Partnerships (MLPs), and other securities with high
dividend yields which could be singled out for exclusion from the benefits
of the tax cut. In many cases they already have special tax status which
allows them to avoid double taxation, and are treated as pass-through
vehicles, similar to S-Corporations. If they get the lower tax rate
they will be wonderful investments. It they are singled-out for exclusion,
however, income-seeking investors will sell these assets to buy other
securities.
Treasury bonds, along with other fixed-income securities, are clear
losers. In the past year, investors have parked tons of money in Treasuries
and bond funds waiting for a better day. If the dividend tax cut ushers
in that better day, as I believe it will, bond yields will rise and
bond prices will fall substantially.
Hard assets that pay no dividends, such as land, commodities, and precious
metals will be affected in a similar way as investors shift from hard
assets, which pay no dividends, to dividend paying securities. Because
of this, the dividend tax cut should be viewed as at least a mild deflationary
impulse on goods prices and inflation rates. I will analyze the impact
of these changes on growth, investment, inflation, interest rates, and
the dollar in a separate paper.
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