Hitting the wrong target

President Bush’s latest tax cut proposal -- $670 billion over 10 years -- appears to have hit the 2004 re-election target. For those hoping his proposal would stimulate capital investment and job creation, Bush’s arrow misses the target altogether.

The latest economic salvo is the fourth fiscal-stimulus package of Bush’s presidency. It follows his 2001 $2.1 trillion 10-year tax cut; the smaller emergency-spending program after September 11, 2001; and the tax incentive for business investment passed in the spring of 2002. It also follows several speeches last summer in which Bush talked about the strength of the US economy while the stock market responded with a Bronx cheer -- plummeting hundreds of points. Under Bush the U.S. has lost 1.5 million jobs.

The most prominent element of Bush’s tax cut is the elimination of dividend taxes at a cost of $364 billion over 10 years. The dividend tax cut would eliminate the income tax that investors pay on the dividend checks they receive from stocks in their portfolios.

While some have praised the dividend tax cut as relief for the ‘investor class’, such wrong-headed analysis masks the underlying reality that there are really two investor classes:
- dividend clippers (individuals who hold high dividend paying stocks); and
- job-creators (executives and investors who build growth companies).

The dividend tax cut rewards dividend clippers and punishes job-creators. This distinction is crucially important for those who believe that the best social policy is a job. How so? Companies that pay dividends tend to be large, slow-growing, government protected bureaucracies like utilities, local telephone companies, and banks.

Companies that don’t pay dividends tend to grow fast – participating in industries such as computer software, computer hardware, pharmaceuticals, and biotechnology. These technology-intensive companies tend to create the most new jobs and the biggest capital gains for their executives and investors. Furthermore, these companies introduce products at the cutting edge of making life better for consumers and workers.

Now consider how the proposed dividend tax cut would motivate both kinds of companies. Dividend-paying companies might see their stock prices rise because they might attract more investors seeking higher and more predictable after-tax returns.

Fast growth companies that do not pay dividends might simply ignore the government’s intent – to encourage them to pay out their cash in dividends rather than reinvest it in the business. Or they might decide to do what Bush’s plan seems to intend -- starve future growth and pay out the cash to shareholders instead.

If job-creators decide to pay out their cash in dividends, the economic impact could be negative. Instead of using their management skill to identify and exploit new growth opportunities, these job-creators would be slowly converted into dividend clippers. The economic result would be anemic capital spending and moribund job growth.

And the dividend tax cut has a little noted blunting effect on efforts to reform corporate financial reporting. By creating an incentive for the payment of cash dividends, clear and understandable reporting of financial results becomes less relevant. Investors will focus less on the financial performance of the companies whose cash flows are the source of their dividend checks.

As long as these checks clear when deposited, investors will care less about the arduous task of actually trying to estimate the future value of the companies. Therefore the accuracy and clarity of financial reporting will become less important and the pressure to reform it will diminish.

For those who are disinclined to analyze a company performance and prospects, the rewards of dividend clipping are self-evident. For those who would have preferred that Bush encourage capital spending and job creation, his fourth fiscal-stimulus package is a disappointment.

Peter S. Cohan & Associates
Two Turner Ridge Road
Marlborough, MA 01752
Office: 508-460-9348
Cell: 508-361-3805
Fax: 508-485-9627
E-mail: peter@petercohan.com
Http://petercohan.com