Wall Street strategists and money managers said today that the centerpiece of President Bush's tax-cut proposal -- eliminating the tax on corporate dividends -- could have a profound impact on how companies finance their operations, on investors of all kinds, and on state and local governments.
For corporations, issuing stock could become more attractive than selling bonds, perhaps limiting bankruptcy filings during bad times. The proposal could also encourage companies to sell "preferred" shares to individual investors and spur companies that do not pay dividends to start doing so. It could also reverse a 20-year trend in which companies use excess cash to buy back stock to increase shareholder value, rather than pay dividends.
For investors, the proposal could encourage a move into stocks from municipal bonds, and from stocks that do not pay dividends to those that do. It could also reward the relatively small percentage of Americans who hold stocks and receive dividends directly over those who own stocks in tax-deferred retirement accounts such as 401(k) plans. The proposal could also cause the value of real estate investment trusts to decline, strategists said.
For state and local governments, the cost of borrowing could increase as higher-yielding stocks emerge to compete with municipal bonds for investors seeking steady income free from federal taxation. Currently, municipal bonds are the primary investment available to provide tax-free income.
Strategists and money managers cautioned that little can be said for sure until details are worked out and the plan emerges from Congress, where it could be significantly altered. Several strategists also said getting bogged down in minute detail could obscure what they view as the most likely impact of a dividend-tax elimination: a modest increase in stock prices overall and an incentive for companies to govern themselves more prudently.
"Most people are focused on who will benefit under this plan. I'm focused on the fact that this could have a positive impact on corporate financial management and that could prove to be the biggest fallout," said Byron Wien, chief market strategist at Morgan Stanley.
Companies might be inclined to issue more preferred stock rather than sell bonds to raise capital. Preferred shares generally pay a set dividend rate, like the interest rate on a bond, but a company could eliminate the dividend during bad times without fear of being forced into bankruptcy. An inability to make a bond interest payment generally leads to default, which gives bondholders the opportunity to force a company into bankruptcy.
The current market for preferred shares is relatively small, because only corporate buyers qualify for a tax break on the value of the dividend. Under the Bush plan, all preferred dividends would be tax-free, perhaps making them attractive to individual investors.
Some Wall Street strategists played down the potential increase in preferred share issuance, noting that companies would still sell bonds because the interest payments on them are deductible from corporate income. Dividend payments would still have to be made with after-tax dollars.
Investors, who over the past two years bid up the shares of companies that consistently paid dividends, would probably move more of their money to dividend-paying companies under the plan, financial strategists said. That would be likely to make more companies to pay dividends.
Tobias Levkovich, chief equity strategist at Salomon Smith Barney, said he heard several chief financial officers say this week that they were strongly considering paying dividends, which fell out favor during the boom in technology stocks of the late 1990s. Then, investors rewarded companies that put excess cash back into research and development and other expenses.
Companies have also been reluctant to pay dividends because they were taxed at a relatively high rate compared with the capital-gains taxes paid when earnings are retained or reinvested or used to repurchase shares from investors, Credit Suisse First Boston noted in a report prepared last month.
But James W. Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, cautioned that because stocks that pay dividends already outperform those that do not, any movement to dividend-paying companies could be limited. A company's long-term outlook will remain the key factor in stock selection because a decline in a company's profits could send its share price plummeting well below the level that any dividend payment could make up for, money managers said.
Several strategists and money managers said they expected to see investors move money out of municipal bonds into high-yielding stocks under the plan.
David R. Kotok, chief investment officer at Cumberland Advisors Inc., said he did not see any panic selling of municipal bonds but that some selling would occur if and when the Bush plans appears to be nearing congressional approval.
REITs could fall out of favor because their dividends would continue to be taxed under the plan. REITs pay no taxes themselves; rather, they distribute the majority of their income as dividends to investors, who are taxed on those amounts. Currently, both corporations and shareholders pay taxes on income distributed as dividends. It's that "double taxation" that the Bush plan seeks to eliminate.
Market strategists and money managers also said that under the plan investors who hold stocks in retirement accounts might suffer because the dividends they earn would still be taxable when they withdraw money from their accounts, while investors who own stocks directly would be exempt from paying tax on their dividends. But Paulsen said he did not expect to see workers move money out of stocks in the 401(k)s.
"For one thing, I think it will be more difficult for people to grasp that issue," Paulsen said. "And for most, the issue is so far in the future they will discount it. Also, if you have a long enough time horizon it probably still makes economic sense to keep stocks in your plan."
Staff writer John Berry contributed to this report.