With the Federal Reserve’s latest rate increase, investors are wondering if the stock market rally that began in mid-August is a head fake and will stall. The answer is no. In fact, the stock market rally has little to do with the Fed. It’s the tax rates.
The election in November is a black and white choice in terms of economic policies. The key economic difference between the two candidates in terms of the economy is their position on tax rates. If President Bush is re-elected he’s almost certain to go back to Congress a second time and ask for a zero dividend tax rate. The dividend tax rate for most people is now 15 percent.
Sen. John Kerry is giving speeches attacking budget deficits. If elected, he is very likely to raise the dividend tax rate back up to nearly 40 percent – about where it was before the Bush cuts. (The top rate for taxpayers then was 38.6 percent.). So investors are looking at a real fork in the road where rates a year from today could be either zero percent or around 40 percent. Those numbers have very different implications for the stock market.
There are also differences between how the two candidates view the personal income tax rate. Bush is in favor of lowering income tax rates. Kerry has indicated he wants to raise income tax rates on upper income taxpayers, those making more than $80,000 a year. But the truth is I expect Kerry will be looking to raise the top marginal tax rate on top earners as well.
Why does that matter? Because 80 percent of taxes collected at the top tax rate are paid by small business owners whose businesses are organized as proprietorships. The profits of the business flow through to the owners’ personal taxes. They don’t generally have financial statements and they don’t discriminate between their own income and the working capital of the business. So the top personal tax rate is a tax on capital for private business.
Although there were other positive things that happened, the dividend tax cut deserves the lion’s share of credit for the stock market gains of the last two years. Indeed, when the cuts were passed the Dow was at about 7,500. Today, it’s hovering around 10,200 -- an increase in the value of shares in the market of more than $2 trillion.
Of course, it wasn’t all due to the tax cuts . . There were other factors at work – productivity growth, big corporate profits, along with the fading of some of the fears rampant two years ago --- for example, 9/11, Enron, WorldCom (now MCI), Martha Stewart, and other scandals. People unclenching their buttocks has People unclenching their buttocks have caused a certain amount of that stock market increase.
How will it work? Two years ago before the tax cuts were announced I did an analysis for the administration. I showed that when dividend taxes are reduced it drives investors into the stock market. They buy dividend paying stocks. They leave non dividend paying assets, such as bonds, collectibles, real estate, non dividend paying stocks, and other assets. Assuming both classes of investments – dividend and non dividend – reap a 10 percent after-tax return, lowering the dividend tax rate means lower taxes so more money goes into investors’ the pockets of pockets investors who own dividend paying stocks. Hence, investors are induced to buy more of this new, better tasting, high return asset – stocks – and sell other assets in the process.
So if Bush is re-elected and the dividend tax rate drops to zero, I predict that’s good for another 10 percent increase in value in the market from current levels within six to 12 months. The caveat is that if Kerry is elected, and dividend tax rates soar to 40 percent, you’d give back all those gains secured over the last two years. The stock market would drop by at least 10 percent. That’s a 20 percent difference in your outlook for the market, which is more than $2 trillion of difference.
The good news is that the gains from the dividend tax cut are still happening. There’s going to be more than we’ve already seen. T o put it another way, think of the dividend tax cut s as a bunker-buster – a bomb wit rh two warheads that explodes and then explodes again . . , sort of two warheads . The first explosion causes investors to change their portfolios in a way as described above. t That reprices all the existing companies’ stocks, and that’s worth that 10 percent increase that a zero dividend tax rate would bring. .
The second warhead is potentially much larger, but will take more time to unfold. It is the increase in value of companies in the stock market that happens as they adapt their behavior to the new tax environment. They’re able to finance operations with dividend paying stock instead of taking on debt for which they have to pay interest. This is more tax-efficient for the investor.
The bad news is that Kerry would take us back to the days before the dividend tax cuts when companies financed operations with debt instead of equity, when they hoarded cash rather than pay it to shareholders as dividends. According to the American Shareholders Association (http://www.americanshareholders.com/news/asadividend06-03-04.pdf), the number of S&P companies paying a dividend declined from 469 in 1980 to 351 in 2002. In 2003, in response to the dividend tax cut, 21 new companies initiated a dividend.
The most visible result was Microsoft’s announcement of their first dividend ever in January 2003. Since then they’ve actually raised the dividend, and in July they paid a special dividend of $3 per common share equal to $32 billion, the largest dividend payout in corporate history. At the complete other end of the spectrum, International House of Pancakes (IHOP) declared its first cash dividend of $0.25 per common share in March 2003, and has made quarterly dividend payments thereafter. The current dividend yield is $2.7 % 0.
Some other high dividend yield stocks today are: Bell South (BLS) 3.91 percent; Bank of America (BAC) 4.04 percent; Citigroup, 3.51 percent. T here is even an ETF (DVY) focusing on dividend paying stocks with a yield of 3.4%. (For comparison, the S&P 500 ETF (SPY) has a dividend yield of 1.53 percent.
In spite of all that companies have done to adapt the dividend tax cuts, they’re still holding back on the $1.5 trillion in cash they could distribute to shareholders. They don’t want to put that piece of meat ($1.5 trillion) into the shareholder’s mouth and jerk it out six months from now when they fear Kerry will erase the dividend tax cuts.
There are two kinds of waiting going on today. Investors are waiting to see what the dividend tax rate will be when they value shares. And managers are waiting to see what the dividend tax rate will be before making decisions about payouts, special dividends and capital structure. They won’t have to wait much longer. |
