The first fixed-income battleground would likely be municipal bonds, since their tax-free interest payments make them favorites of income-oriented investors. Some think the proposed change would put them in direct competition with tax-free stock dividends. Adding to that potential problem, many municipal issuers have experienced severe downturns in tax revenue and credit downgrades.

Making dividends tax free would add even more revenue erosion to the equation, since most states figure their income taxes based on adjusted gross income reported on federal returns. If dividends aren't counted in the AGI calculation, states would get less tax revenue unless reporting methods changed. "Some states are in bad shape now," says Stephen Carpenter, vice president and senior portfolio manager at National City Bank in Cleveland. "This would just add to the problem."

Yet Carpenter maintains that the long-term effect would be minimal, and that the economic stimulus provided by the tax cut would help offset the revenue loss. "As an asset class, municipal bonds are fairly stable," he says. "I just don't believe that people who buy municipal bonds are the same ones who will run to the stock market."

High yields relative to taxable issues might help persuade them to stay put. "A ten-year, triple-A rated municipal bond has a tax-exempt yield of 3.8%, about 92% of the yield on a ten-year Treasury bond," says Carpenter. "The 1.7% dividend yield of the S&P 500 isn't in the same ballpark."

Stocks: Juicier Dividends

Stocks with high dividend yields in sectors such as utilities, telecommunications and energy enjoyed a nice "pop" in January after President Bush announced the tax proposal. But stocks that pay little or no dividends, as well as the overall market, could also benefit in the longer term.

"If the tax on dividends were lowered or eliminated, I know that a lot of companies in my portfolio would like to double or triple their dividends, or start paying them," says Blaine Rollins, manager of Janus Fund. Maxim Integrated Technologies, one of the fund's largest holdings, paid its first dividend in November in response to increased investor demand for dividend-paying stocks. In January, cash-rich Microsoft declared its first dividend of 16 cents a share. While that represents a dividend yield of less than 0.3%, it opens the door for institutional investors and mutual funds limited to investing in dividend-paying stocks.

Jeff Van Harte, head of equities for Transamerica Investment Management in San Francisco, says a number of the growth stocks he invests in are generating large amounts of cash and would be able to pay a dividend without impacting their growth rates. Yet he characterizes the potential impact on the overall market as relatively subdued.

"Reducing or eliminating the tax on dividends would produce perhaps a 5% to 10% increase in overall stock prices," he adds. "The bigger impact would come if it helps companies make better capital allocation decisions. Many of them destroyed shareholder value by using their cash to make ill-fated acquisitions. This would force them to re-evaluate those strategies."

The most obvious and immediate beneficiaries of a reduced or eliminated dividend tax would be companies that already pay a dividend. Patrick Horan of Horan & Associates in Towson, Md., says dividends are not a primary consideration for him, but a number of stocks he owns offer above-market yields that would be made more attractive by tax-free status. His holdings include catsup and food producer H.J. Heinz, which has a 4.82 % dividend yield and sells at just 15 times estimated 2003 earnings. "This isn't a huge grower, and it's had some management issues," he says. "But it's a brand name with a good product line and a solid history of earnings."