Less Is More
rutledge, john
D on't turn the page! President Bush's plan to end the double taxation of corporate profits has unleashed a tsunami of words. Some purport to tell us why zeroing out today's 38.6 percent tax rate on...
...2. Corporate restructuring will drive the next decade Financial markets adjust to change quickly, but flesh and blood companies will get there, too, as astute managers use the new, lower rates to lower capital costs and become tougher competitors...
...President Reagan had pushed through a massive reduction in the top marginal tax rate, creating a huge disequilibrium between the after-tax returns of securities on the one hand, and hard assets and tax shelters on the other...
...The dividend tax cut will reverse this trend...
...The resulting "temperature" differential induces investors to rebalance their portfolios by selling non-dividendpaying assets to buy paying ones...
...Money follows the same rule, but runs the other way: uphill—from lower to higher after-tax returns...
...Overall, going to a 100 percent dividend-payout ratio for the S&P's Information Technology sector would increase equity values more than 40 percent...
...The irony is that companies that already pay dividends will have the least flexibility to improve their value, while those that don't have the most to gain...
...Expect today's declining dollar to reverse, with total returns from U.S...
...7. Don't get greedy Two days after President Bush announced his plan, stock prices had already risen 5 percent, about half the initial impact predicted...
...That won't happen overnight, but shareholders will exert pressure on managers to increase payouts and deleverage—and managers who own stock or stock options will3...
...As I described a few months back ("Thermo Economics," TAS, July/August 2002), all economic change is a special case of the First Law of Thermodynamics...
...It starves ventures that produce large, reliable cash streams in favor of those that produce no profit (nothing to tax), instead promising future (and minimally taxed) capital gains...
...Most preferred stock issues today are actually so-called "trust preferred securities," a vehicle corporations have used to (surprise) shelter taxes...
...And just the right time to do it...
...These arguments make no sense at all...
...The first reason they make no sense has to do with the flawed models the economics industry uses to project budgets: They calculate revenues by assuming that people pay taxes at the lower rates, but take no account of the offsetting increase in revenues from stronger growth and higher capital gains...
...Newly richer investors need new securities to deploy their new net worth including government bonds...
...Just the fuel we need to get this bus moving again...
...It also fueled the idea that paying out dividends implied management's failure to find good investments...
...Telecommunications, 33 percent or $132 billion...
...4. The budget deficit is not a problem You will hear a-lot of economists and politicians screaming that the dividend tax cut will destitute your children by ballooning the budget deficit, driving up interest rates, and pushing the economy deeper into recession...
...The short answer is: No—this is a change for the long run...
...In the early 1980s we faced a similar situation...
...Some purport to tell us why zeroing out today's 38.6 percent tax rate on dividend income is either 1) the best or 2) the worst thing that has ever happened, typically based upon the writer's political angle...
...Last but not least, hard assets—land, commodities, and precious metals—will share the same fate as other non-dividendpaying assets...
...How much...
...Here are the seven things you really have to know: 1. You have several trillion reasons to stay—or get—invested Open your pockets wide...
...Cash-rich technology companies such as Microsoft, Intel, and Cisco—those three alone have nearly $60 billion under wraps—will have enormous latitude to deliver value to shareholders by paying large one-time dividends...
...5. Here lies danger Not everything is coming up roses...
...Watch out for a similar head fake from real estate investment trusts—REITs—as well as from "master limited partnerships" and other securities with high dividend yields...
...Prices of both capital equipment and consumer goods are going to have to firm somewhat—or at least stop falling—to make the stimulus effect work...
...It will not go away quickly...
...The resulting rush into bad deals—any deals—underlies many of the recent governance scandals...
...Then—as now—we heard howls from economists who argued the tax cuts wouldn't work or that the budget deficits would then drive interest rates even higher than their 20 percent levels...
...Those that do, on average, pay out a lower share of profits, or use stock buybacks in their place...
...capital relative to returns elsewhere, leading to a wholesale rebalancing of global portfolios, similar to what happened in the early Reagan years...
...Such "static" reasoning, which assumes that the tax policy will fail to increase growth, has been used skillfully by the Congressional Budget Office and the Joint Tax Committee to defeat tax-cut proposals...
...How...
...Ignore them...
...Some tell us how to rearrange our affairs to squeeze every last penny of vigorish out of the deal...
...The dividend tax cut is good for the eeconomy Double taxation of dividend income has created what economists dryly refer to as inefficiencies in our capital markets...
...Along the way, the total market value of equities will increase, and the net worth of investors with it...
...This distortion of managerial incentives was a material contributor to both the excesses of the stock market boom in the late 1990s and to the severity of the subsequent correction...
...Higher stock prices and a more liquid market for new shares will boost economic growth by making companies more interested in buying (and less interested in selling) capital equipment—good news for equipment makers' pricing power, production levels, and profit margins...
...Consumer Discretionary, 15.5 percent or $202 billion...
...This pushes prices on dividend payers up and prices of nonpayers down until a new equilibrium has been established, and relative returns are back in balance...
...The Fed needs to provide the liquidity to allow this to happen without jerking interest rates higher...
...In recent years, paying dividends has gone out of style: only one in five public companies today pays a dividend, compared with two-thirds as recently as 1978...
...and HealthCare, 7.9 percent or $108 billion...
...That's just shy of $800 billion in new net worth...
...The First Law states that heat will flow from a warmer to a cooler object until their temperatures are equal, a state physicists refer to as thermal equilibrium...
...equities look very attractive over the next five years...
...markets outpacing the world...
...The tax code already treats them as pass-through vehicles, similar to S-corporations, allowing their owners to avoid double taxation...
...asset markets since the 1981 Reagan economic plan—a massive storm that will revalue everything from stocks and bonds to real estate and the dollar...
...Watch prices fall, just like they did in the 1980s, as investors en masse shift their portfolios toward dividend-paying securities...
...By triggering the biggest event to hit the U.S...
...6. Don't short America The dividend tax cut will increase the after-tax return on U.S...
...I have boiled all this down to the essence of what you have to know, so you can go back to earning a living, gladly agree...
...But not all companies, sectors, or industries are created equal: The biggest increases in after-tax return—and therefore the biggest price jumps—will accrue to those companies that pay big dividends...
...A dividend tax cut instantly raises the rate of return for dividend-paying assets—their temperature, if you like—relative to the return on other assets...
...But look—or better yet, get good advice—before you leap...
...Even wider than that...
...If the dividend taxcut ushers in that better day, as I believe it will, yields will rise and bond prices will fall substantially...
...I hope that Ronald Reagan knows that the Reagan Revolution is alive and well in America...
...President Bush's dividend tax cut is going to stuff nearly a trillion dollars of new net worth into your jeans by increasing the value of the stock market...
...To mix a metaphor, heat flows downhill...
...Any increased budget deficit caused by the tax cuts will be small and temporary, no more than a rounding error in the nation's balance sheets...
...In the past year, investors have parked billions of dollars in bond funds, waiting for a better day...
...See "Untaxed Dollars Don't Die," p. 5.) The second reason the budget doom-criers are wrong is that deficits of 1 or 2 percent of GDP are chump change to our capital markets...
...Add 20 percent on top of that—our calculation of the present bear market's undervaluation—and the returns from U.S...
...And they can raise stock prices by diverting free cash flow to future dividends...
...Preferred stocks, with their high dividend yields, may seem like an obvious play, especially once corporations start issuing more of it to reduce their debt...
...or reading THE AMERICAN SPECTATOR...
...For consumer goods, the initial $800 billion of added net worth will also help firm prices—grab those sales incentives now—and will show up in the national income accounts as stronger consumer buying and stronger GDP growth...
...No, wider...
...Companies that are leveraged can increase value even further by selling shares to reduce debt...
...Some purport to explain the merits of singling out one group or another for special consideration...
...For the S&P 900—the S&P 500 large-cap stocks plus the S&P 400 mid-cap stocks—my colleagues at Rutledge Capital and I calculate that cutting the dividend tax will require an average equityprice rise of 8.5 percent to restore equilibrium...
...A sharp drop in inflation amplified the gap, setting up a situation not too different from today's...
...Treasury bonds, along with other fixed-income securities, are also clear losers...
...Something like that could happen again, and when it does, the Bush dividend tax cut will be recorded as one of its drivers...
...Are the changes already "priced in...
...Their dividends are treated as interest income on your tax returns, and thus will derive no benefit from the dividend tax cut...
...For exactly that reason they're specifically exempted from the Bush cuts...
...After that, corporate managers are going to stuff another trillion or two more...
...Fortunately, the directors of both offices were replaced in January, by people who understand the importance of dynamic scoring...
...And mostly upward...
...Using 2001 figures for dividend payout and equity capital ratio, sectors with the biggest potential jumps in value include: Industrials, 21 percent or $225 billion...
...is...
...What we got instead was just short of two decades of falling interest rates, rising stock multiples, and wave after wave of corporate restructuring that left America the preeminent economic power in the world...
...In other words, we need at least a bit more inflation...
...Have we already missed the boat...
...One sidelight: The Fed has an important role in helping this happen...
...That shift will be magnified by Japan's gnawing deflation and by Europe's continued stagnation...
Vol. 36 • January 2003 • No. 1
