By DAVID MOON, Moon Capital
February 16, 2003
US News and World Report recently criticized President Bush's proposal to
eliminate federal income taxes on corporate dividends as potentially harmful to
traditional tax advantaged investments. In a February 3 article, the
magazine presents a list of losers from the proposed tax cut, including
municipal bonds, real estate investment trusts (REITs) and small company
That's a pretty shallow argument from a publication that typically treats
issues with much more depth. It's also disappointing coming from a
publication that generally understands the notion that a benefit for one group
of people is not, de facto, a detriment for some other group.
The general argument is that if corporate dividends aren't taxed at the
individual level, individuals will find the stocks of high dividend companies
more attractive. So far, so good. But the argument falls apart when
extrapolated to conclude that if a tax cut makes some investments attractive,
then the other investments must be less attractive.
For example, payouts from REITs will still be taxable under the president's
proposal, although these payouts look like corporate dividends to the average
shareholder. But they aren't normal dividends, because REITs do not pay
federal income tax on their earnings. The federal tax code allows REITs to
avoid paying all federal income tax if they meet certain conditions, including
paying a minimum amount of their earnings in the form of annual distributions to
their shareholders. REITS have more cash available to pay dividends
because they don't pay taxes. The whole intent of eliminating taxes on
dividends is to eliminate the double taxation of corporate earnings. REIT
earnings currently suffer no similar double taxation. They have benefited
from special provisions in the tax code designed specifically for them. It
seems a bit of a stretch to call REITs a "loser" simply because another form of
incorporation may receive the exact same benefit REITs have received for years -
that is, single taxation of their earnings.
Is it likely that some stocks will be more attractive if investors can exempt
the dividends from those stocks from their taxable income? Of
course. But making one stock more attractive does not make another
investment less attractive. When a large and widely owned stock
announces a piece of financial news, the news often impacts the entire stock
market on that day. If Microsoft announces better than expected earnings,
it is not uncommon for the prices of all sorts of companies to react
positively. If higher earnings make Microsoft a more attractive
investment, does that mean that every other stock is now less attractive?
Apparently not, since their prices often move in tandem. So why should an
action that increases the attractiveness of a high dividend stock like Phillip
Morris (or, more appropriately, "Altria," the new name for Phillip Morris) cause
a decline in the value of Cisco Systems, a stock that pays no dividend?
A couple of weeks ago, I wrote about the philosophical deficiency of thinking
of the economy as a fixed-size pie, where increasing the size of any piece
geometrically resulted in a smaller remaining pie. The economy isn't a
fixed size. Nor is the capital market.
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).