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Henry Paulson defends the dividend tax cut
Here is the closest I find to a formal economic argument from the man. In this WSJ Op-Ed, if my eyes catch the fine print correctly, Paulson argued that the Bush dividend tax cuts will add 5 to 20 percent value to the stock market. (Here is my source, though I cannot find a permalink. And here is my source's critique of the idea, although on this screen my old eyes cannot read it.)
I've never understood the Paulson argument for two reasons. First, at least in theory paying dividends should lower the value of the firm, relative to capital gains, given the higher dividend tax rate at the time. Dividends would appear to shift around the form in which wealth is held, pulling it from one pocket to another, rather than increasing wealth. I am the first to admit the entire topic of why dividends are paid is poorly understood, but that uncertainty does not militate in favor of targeting dividends for early and primary tax cuts. I would sooner cut or abolish the corporate income tax, for instance.
Second, for any given level of government spending, the wealth effects of the dividend tax cut (if those effects exist in the first place) are a transfer to equity holders and from....? Well, that remains to be seen. Stay tuned for your forthcoming tax increase...Some of you, that is...
Addendum: I should make the broader point that this pick is probably very good news.
Posted by Tyler Cowen on May 30, 2006 at 12:29 PM in Economics | Permalink
Comments
Talk to anyone and they'll tell you about the many mistakes Bush has made in office, but this is one issue where I think he at least took a step in the right direction.
A low book value stock that doesn't pay dividends isn't much different from a baseball card. It’s just a piece of paper. Remember, those of you who had any finance courses, the good ‘ol Gordon Growth model? Back in 2000 when I was getting my undergrad degree in Finance it was such a joke to figure out what the price of a stock should be, according to the GG model. P/E ratios were almost always north of 40, and due to the double taxation companies weren’t paying dividends.
We didn’t plunge into a depression after the irrational exuberance of the late-90’s but the financial world did lose their heads a bit, and the hangover was still nasty for many out-of-work people.
You buy a stock to own a company… but you buy a company because you want a piece of their action, a disincentive to pay dividends keeps investors from sharing in those profits. It corrupts stock market valuations, feeding speculation. Don’t get me wrong, I understand that valuation is a very subjective term… but it’s a snowball effect.
If you remove the disincentive to do what profitable companies should do (which is repay their shareholders), then investors will demand that companies reward them for taking the financial risk they do. ‘Good’ companies will valued, and those companies who don’t make a profit will have less capital available, in which to run up their stock only to see it tank when everyone sells off and moves onto the next shiny piece of paper.
Posted by: Andy at May 30, 2006 1:08:15 PM
The Chicago answer is that paying dividends adds value to the economy and the company by discouraging managers from sitting on big piles of cash, which they ultimately usually seek some stupid use for.
Posted by: Jane Galt at May 30, 2006 1:08:44 PM
Well elminating the corporate income tax is not a politically feasable.
Cutting the tax on dividends should, in principle, raise the return to holding shares. Though, the shareholder doesn't require that the company actually pay dividends, she should require it be theoretically able to distribute profits in some manner.
Put another way - Suppose I am currently indifferent between buying ACME Inc lock stock and barrel then sucking out all the profits or instead putting my money in bonds. Now the dividend tax is repealed. I am no longer indifferent. I would rather buy ACME and suck out all the profits. Thus the price of ACME must rise.
Posted by: Karl Smith at May 30, 2006 1:20:02 PM
Another reason I've heard for dividends is that it keeps the company honest. You can say you have all the money in the world, but if you don't actually have the money then you can't pay dividends.
Posted by: Nathan Whitehead at May 30, 2006 1:32:31 PM
At the very least, dividends that the investor chooses to reinvest in the same stock should be tax exempt
That way you can invest in companies that pay them as a way to avoid accounting scandals (the saying on Wall Street is "you can't fake Cash") without taking income.
Posted by: Jim at May 30, 2006 1:45:59 PM
I understand the concept behind the theory that a cut in the tax rate will lead to a lower cost of capital and greater investments.
But I have a couple of big problems with the data behind the theory.
First, if you look at the data you find that for every dollar raised in the stock market coporate america pays out some two to three dollars in dividends. So on balance the stock market is largely a mechanism to transfer income from corporate profits to private consumption. the theory ignores this issue.
Second, the nature of firms that raise money in the stock market and the firms that pay dividends is very different. In general dividend payers are more mature firms with lower prospects for profits growth.
While in contrast firms that issue new IPOs are generally young companies with prospects for very fast profits growth that do not pay dividends. So why should the tax rate I get on the dividend from a mature company influence the value I place on a new IPO -- I do not see the relationship.
An outstanding review of the issue can be found at
http://www.bos.frb.org/economic/ppdp/index.htm.
P.S. at least for large cap stocks the stock market PE has fallen since the new tax policy was implemented so at least for now there is little evidence that the
tax cuts on dividends has contributed to the current cyclical repound in capital spending.
Posted by: spencer at May 30, 2006 1:47:31 PM
Do note, by the way, that companies often raise new money for their managers at the same time they are paying dividends. Easterbrook (AER 1984?) makes some progress on this issue but it remains a puzzle.
Posted by: Tyler Cowen at May 30, 2006 1:49:28 PM
that companies often raise new money for their managers at the same time they are paying dividends. Easterbrook (AER 1984?) makes some progress on this issue but it remains a puzzle.
Isn't one idea here the notion that external financing provides a check on the value of the project? In other words, you avoid the free cash flow problem by requiring outside validation that the proposed use of funds makes sense.
Posted by: Bernard Yomtov at May 30, 2006 1:50:54 PM
spencer wrote: "First, if you look at the data you find that for every dollar raised in the stock market coporate america pays out some two to three dollars in dividends" and "In general dividend payers are more mature firms".
Isn't that how it should be? Dividends compensate investors for risk and for the time value of their money, and (as you said), a company has to mature for years before it can pay them. Yes, to compensate those investors, successful companies will pay out much more in dividends than they raised in equity financing.
For the same reason, over 30 years a homeowner might pay the bank 2-3 times the original mortgage principal.
Posted by: DK at May 30, 2006 2:25:13 PM
"Well elminating the corporate income tax is not a politically feasable."
Says who?
Posted by: Max at May 30, 2006 2:47:35 PM
I am not saying it is or is not the way it is suppose to be.
The theory is that the dividend paid out by a mature slow growth firm will be reallocated to new, faster growth companies.
But in reality the money raised by new firms in the stock market only ammount to some 25% to 33% of the ammount paid out in dividends. the theory that cuting the dividend tax will
lead to higher investments assumes that this money flows back into investment rather then consumption and that just is not the case.
Some 66% to 75% of the money paid out in dividends goes into consumption, not reinvestment.
By the way jane Gault in the US economy some 82% of nonresidential fixed investment is done by corporations, another 7% by non-profits and only 11% by individuals and entities subject to the individual tax code. Given these ratios the Chicago school
belief does not seem to have much to do with the real world.
Posted by: spencer at May 30, 2006 2:54:35 PM
Here is a tax fairness point. Why should dividends be after tax from the company, distributed to the shareholder and then be taxed again? It is being taxed twice within the same year.
Posted by: Patinator at May 30, 2006 2:56:23 PM
Patinator --- you are right and it makes the entire more complex.
In my personal tax code I would eliminate the corporate tax
and treat all income the same. but in reality that is a nonstarter.
Posted by: spencer at May 30, 2006 3:42:11 PM
Spencer, IMHO, the comparison you are making is not time consistent. You are comparing present-day dividends (the products of past investment, primarily going to older people who use them to finance current consumption) with present-day investments (primarily made by younger, less risk-averse people planning to finance future consumption). Instead, you should be comparing past investments to current dividends and current investments to future dividends.
I have not heard the theory you mention that dividend tax cuts are supposed to cause the retirees who receive most dividends today to invest more and consume less. The Bush administration may have claimed that, but that doesn't make it a theory. The theory I've heard is that the tax cuts should improve the incentive to make investments today for dividends tomorrow. and yes, as Tyler says, this theory is also flawed.
Posted by: DK at May 30, 2006 3:45:16 PM
Less of this unfair taxation business please. Most people likely bought their stocks when taxes on investment income were heavier at a price which refelected that. A tax cut now is a freebie at the expense of other taxpayers.
By all means remove distortions in capital and funding structures, even takes steps to reduce the cost of capital if for some reasons it seems too high, but fairness isn't really an issue.
Well maybe it is. Not everyone who owns shares pays the same tax. Those that don't pay as much get a good deal because prices are held down by the squashed demand of those who do.
Posted by: Jack at May 30, 2006 4:42:56 PM
If you have not heard the theory that the money paid out in dividends is not suppose to go back into investment I suggest you go back and read what Jane Gault wrote and ask her to explain the Chicago school analysis.
I also will cite the data I brought up earlier that 82% of nonresidential fixed investment is done by corporations and only 11% by individuals, s-corps, etc.
If you expect an increase in their rate of return to lead to higher invesments you better argue that there is a very, very, very, big response.
If you want to encourage investments the tax efficient way to do it is to cut corporate taxes.
The presidents dividend tax cut is just another case of trickle down economics.
Posted by: spencer at May 30, 2006 4:49:53 PM
I agree with you spencer (and Tyler) that cutting corp taxes is a much more efficient way to do this. But I am still missing the bit about redirecting consumption to investment. The original article by Paulson actually says the opposite -- it says the tax cuts will help improve retiree incomes i.e. more consumption!
Posted by: DK at May 30, 2006 5:00:08 PM
You're all looking at the wrong margin. Taxing dividends twice favors debt over equity, because interest payments, unlike dividends, are deductible for the corporation. The dividend tax is a leverage subsidy. It increases the riskiness of capital structures and also exacerbates agency problems with getting cash out of managers' mitts and back to the shareholders.
Posted by: srp at May 30, 2006 5:57:22 PM
Yes but is as important as stock options?
Posted by: Jack at May 30, 2006 6:55:45 PM
The temporary status clouds the issue a lot. Efficient capital structures are a long term gain (Microsoft's cash pile aside) and the capital won't be cheaper if the market thinks the low rates won't last.
Encouraging leverage is not such a bad way of keeping cash out of managers hands. Anyway, we got here with what we've got or worse so it is obviously not entirely disastrous.
Posted by: Jack at May 30, 2006 7:01:36 PM
Jane Galt's actual comment was:
"The Chicago answer is that paying dividends adds value to the economy and the company by discouraging managers from sitting on big piles of cash, which they ultimately usually seek some stupid use for."
I don't see where she says "dividend payments will be re-invested" or anything of the sort. In fact I don't think this has much to say at all about what the payments are used for. The real point is that the money flows to stockholders instead of being wasted by managers.
Posted by: Noah Yetter at May 30, 2006 7:06:32 PM
Earlier this year there was an article by someone complaining entirely too much money was being paid out in divvies, IIRC, about $1700. Ours went into our IRAs and I have no problem w/that.
Posted by: Sandy P at May 31, 2006 12:36:31 AM
This has been one of the most lucid discussions of dividends that I've ever come across. My hearty thanks to all of you out there enriching my life and filling my mind with theory anew. Believe me, where I live, hearing this sort of talk is like drinking water after a desert...
Posted by: Robert Nanders at May 31, 2006 2:04:35 AM
With regard to issuing debt versus equity from the perspective of firm management:
I cribbed this from an article in the Economist (feb 9th, subscription required). There are several potential agency problems including, "insufficient effort; extravagant investments; entrenchment strategies (actions, such as anti-takeover “poison pills”, that are costly to shareholders and make it harder to remove managers); and self-dealing"
Issuing debt is supposed to help with the effort problem because a bond legally obliges managers to pay interest and repay the sum borrowed on specified dates. Reducing dividend taxes would make it cheaper to pay out earnings as dividends and would help with at the second problem, hopefully reducing extravagant investments.
So it isn't clear which form would be prferable to owners from this point of view.
My two cents: I think that reduced dividend taxes would mainly help mediocre businesses and increase their share prices relative to exceptional businesses that are growing, plowing back earnings, and harnessing the power of compound interest tax-free.
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