Good Idea, Dubious Timing

President Bush‚s plan to eliminate the double taxation of corporate dividends represents an overdue recognition that the capital markets are increasingly competitive and global in scope. After all, America is the only major nation in the world that taxes dividends twice, placing U.S. companies at a competitive disadvantage when competing for investment dollars.

For decades, the U.S. tax system has penalized dividend-paying equity issuers, while subsidizing corporations that borrow and deduct the interest. These facts of corporate life played a key role in the leveraged buyout boom of the 1980s and fueled America‚s love affair with debt.

But while the proposal makes common sense, its consequences are far from clear. What‚s truly amazing is that the potential elimination of one tax enacted decades ago could radically rearrange the balance of power among different investment vehicles. Nobody knows where this ripple effect will end.

For years, state and local governments, along with other municipal bond issuers, were key beneficiaries of the uneven taxation of interest and dividend payments. Leveling that playing field is sensible, but it could hardly come at a worse time for municipal bond issuers, many of which are wrestling with their worst budget deficits in 50 years.

The precise impact of the president‚s proposal on municipal issuers remains to be seen. At the margin, it would seem that they might have to offer juicier yields to compete for capital.

The impact on corporate finance is even more opaque. Some experts predict that preferred stock could gain dramatically in popularity, eating into a substantial share of the corporate debt market, since investors would expect a higher yield from corporate bonds with taxable interest payments than from preferred stock with tax-free dividends. Still, given the deductibility of interest payments, corporate debt will remain a viable option.

Companies would certainly have a greater incentive to pay dividends, but it‚s not clear that this is always a good thing. Indeed, one could argue that the disincentives embedded in the old system discourage U.S. companies from paying significant dividends and encourage them to reinvest in their operations.

Higher rates of return on reinvested capital has helped make American companies more competitive and their workers more productive over the last 15 years. But much of the current economic downturn was triggered by a capital-spending boom in the late ‚90s that resulted in sub-par returns on investments.

Some skeptics fear that the new proposed law could seduce companies into a race to pay the highest dividends, siphoning off funds for future investment. That‚s unlikely, because American business is so competitive today that rivals will capitalize on any apparent slippage they can find.

Those who expect the elimination or reduction of taxes on dividends to jump-start the economy are deluding themselves, I‚m afraid. Two years ago, the Federal Reserve Board began cutting interest rates, eventually lowering the Fed funds rate from 6.5% to 1.25%. If that couldn‚t resuscitate the economy, don‚t expect wiping out taxes on dividends to help at all.