Flak about dividends is unfair

By DAVID MOON, Moon Capital Management
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 stocks.

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).

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