In the weeks since Congress slashed the tax on dividends to 15 percent, stocks that pay dividends have fared worse than their brethren who stubbornly refuse to share their earnings with shareholders. According to Standard & Poor's, between the beginning of June and mid-August shares of dividend-paying members of the S&P 500 rose 2.5 percent, while shares of nonpayers rose 3.9 percent. And the goose provided by dividends—2.174 percent annually for payers—doesn't come close to making up the difference.
The recent performance wouldn't be so mystifying if investors, having anticipated passage of the measure, had priced in the gains that we were assured would accrue to dividend-paying stocks. But, as Standard & Poor's has noted, from the beginning of the year, when discussion of such a tax reduction began in earnest, through Aug. 4, dividend-paying S&P 500 stocks were up 13.61 percent, while nonpayers were up a whopping 31.74 percent.
Last week Holman Jenkins of the Wall Street Journal editorial page said this disparity is no mystery, and that "even supporters of the tax cut should have anticipated lagging share-price performance for companies that immediately up their dividends." Companies and their shares can generate only a certain amount of returns, which get funneled into investors' pockets either through dividends or capital gains or by some combination thereof. Therefore, comparatively greater dividends would be expected to lead to comparatively fewer capital gains. Besides, he said, raising stock prices wasn't the point of the tax reduction in the first place."The appeal resided not in hopes of higher share prices but in hopes that it would make capital allocation across the economy more efficient."
Perhaps Jenkins didn't get the memo. Over the past year, as the dividend tax cut gained momentum, supporters of the measure, from President Bush on down—"See, by ending double-taxation of dividends, we will increase the return on investing,"as he put it—relentlessly argued that it would boost asset prices, create jobs, and do everything short of curing polio. What's more, many have viewed the spring's stock market rally—in other words, an increase in the price of stocks, not the total return created by stocks gains and dividends—as a sign that the policy is working.
In December 2002, about when the dividend tax cut meme got started, CNBC talk-show host and National Review columnist Lawrence Kudlow touted the proposal as a way "to remedy sinking equity values and impoverished investor returns." Kudlow—whose assurance is matched only by his capacity for issuing loonily high forecasts—concluded, "With earnings remaining at the same volume, the dividend tax cut and the related increase in after-tax capital returns provides a 30 percent boost for equity asset values." Not total return, but equity asset values.
In January 2003, when the dividend tax cut was getting legs, the Wall Street Journalreported, "Administration officials earlier cited studies suggesting the value of equity markets likely would rise by about 10% from dividend-tax elimination, though they no longer use that number." And Business Week reported that "as a Columbia University economist in the 1990s, White House economic adviser R. Glenn Hubbard estimated that a full repeal could lift stock valuations by as much as 20%." Again, stock valuations—not total returns. In June, appearing on Ben Wattenberg's PBS show, Hubbard said, "So if you ask yourself what change in tax policy could both reduce the cost of capital for business investment and help reflate asset values, [my italics] there's only one category of policy, which I'm aware, which would be cutting dividend and capital gains taxes."
Just last week, economic forecaster Michael Evans wrote in Industry Weekthat "if the top dividend rate is at 15%, down from 38.5%, during the next two years, the stock market will rise by 10% to 20% more than otherwise would have been the case." In other words, investors would be prepared to pay higher prices for a market in which constituents pay tax-favored dividends.
There's no question the dividend tax reduction has encouraged more companies to boost dividends. According to this study by Standard & Poor's, among companies in its S&P 500 index there have been 171 dividend increases and initiations in 2003, up from 113 in 2002. But the fact that more companies are paying more dividends hasn't, by itself, caused investors to bid up shares of the companies that pay dividends
Perhaps taxes don't motivate investors as much as people like to think. After all, in periods when capital gains were taxed either at the same rate as dividends or at a more favorable rate than dividends—especially for stockholders in high marginal rates—one would have expected nondividend-paying stocks to perform better. Under such a regime, the nonpayers had the capacity to deliver the most tax-efficient returns. But it turns out that wasn't the case. Standard & Poor's concluded in that same study that, between 1980 and 2002, companies that paid dividends performed 2.7 precent per year better than nondividend-paying stocks.
Let's accept for the moment Jenkins' argument that the expected result of reducing taxes on dividends would be to turn dividend-paying stocks into comparative underperformers. If so, then, the Bushies have managed to turn the same trick they first performed on the whole economy on a subset of the economy. They've turned a perennial outperformer into a chronic underperformer.