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January 22, 2003

US Dividend Taxes
by Andrew Smithers

The US government proposes to cut the taxes paid on dividends. The motive for the change differs from the reasons given. As the motive is political, the economic impact will obey the law of unintended consequences. As the excuse is a blind, the debate has tended to produce more heat than light. The motive is to make life better for shareholders. 89% of Americans own shares, the rest are not likely to vote and the few who do are unlikely to vote Republican. It is therefore hard to fault on political grounds, provided voters are driven by self-interest.

It has three political soft spots. First, voters might be compassionate and dubious about benefiting capitalists at the expense of workers. Second, most voters are both capitalists and workers and may not choose to back the former. Third, voters may worry about the budget deficit.

To skirt these weak points, an economic excuse was thought to be needed. The one chosen is nonsense. The excuse is that taxing dividends is "double taxation" since they are paid by corporations from their after tax income. This is true and bogus. We are double or treble taxed all the time. We pay tax on our capital, tax on our income and tax on our spending.

This is sensible rather than obnoxious. Taxes should be low at every level, as high rates encourage evasion. Double and treble taxation is thus sound sense.

Viewed from the narrow self-interest of financial journalists, it would be good news if the economic or stock market consequences were not only unintended but huge. In fact they are likely to be meagre.

The change will have both a direct and indirect impact. The first will come as part of the general programme of tax cuts. The resulting rise in the budget deficit is, however, rather small. The stimulus to the economy which they will give is welcome, because the economy needs help, but it looks sadly modest in terms of the amount of help that is needed.

The indirect effects will come through the changes in behaviour which the change in taxation will encourage.

The return on shares to investors has been stable at around 6% p.a. before tax over the long term. During this time, the taxes paid by individual investors have varied greatly. All prices are determined at the margin and the stability of the pre-tax return suggests that the marginal investors who determine the return on shares are those who pay no taxes.

As the pre-tax return will not be affected, individuals will benefit by being allowed to retain more of this after tax and having to give less of their income to the government. On unchanged prices, US individual investors will then prefer US shares to other investments, such as property, bonds and foreign shares.

This will support the dollar, though it seems unlikely that the effect will be significant. Relative changes in monetary policy, as well as a myriad of other factors, are likely to be far more important in influencing exchange rates.

One asset class that should be affected is US municipal bonds. These are tax free to US individuals, who are therefore likely to be the price-determining buyer.

A longer term effect may come through encouraging companies to pay out higher dividends. Unless companies also choose to increase their debt, this will be offset by a reduction in share buy-backs and a rise in new equity issues.

This is good news for investment bankers, who could certainly do with some good news. It might even help the Republicans raise money from Wall Street.

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

Copyright © 2002-2007 Andrew Smithers

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