Wednesday, January 08, 2003

The Bush administration is now proposing eliminating the tax on shareholders' dividend income. The claimed practical justification for the move is that it will function as a fiscal stimulus to the economy; I will leave it to others to criticize it on that score. Personally, I continue to doubt (as I have mentioned before) that a fiscal stimulus of any kind will be any more effective at curing America's post-bubble malaise than have the trillions spent over the last decade building bridges to nowhere in Japan.

There is also, however, a "principled" argument being made for cutting taxes on dividends: that dividends are "double-taxed", since they are drawn from profits that are themselves subject to a corporate income tax. Of course, all other business expenses, from purchased merchandise to employee salaries to interest on loans, are drawn on those same profits. The special status of dividends is thus based on a presumptive difference between owning a share of a company's stock (and hence a claim on a share of its profits) and merely providing it with a service (such as floating it a loan or working for it as an employee).

As a practical matter, though, that difference is becoming fuzzier all the time. On the one hand, instruments such as mutual funds erode the "control" aspect of ownership to the point of negligibility; on the other, complex modern financing arrangements can make bondholders' returns very nearly as much a function of market performance as common stock. Indeed, if the tax cut goes through, I would expect to see numerous future issuances of "preferred stock" under terms that make them look remarkably like bonds, with promised dividends in place of promised loan repayments. Encouraging lending and investment to be cosmetically restructured in this manner to satisfy arbitrary tax rules can't possibly be economically useful. Or can it?

I am referring, of course, to the elephant in the room that gets passing mention but whose shocking implications are rarely addressed head-on: that the dividend tax cut may well be a naked attempt to influence the stock market. As the estimable Stephen Roach of Morgan Stanley has pointed out, it is tempting for policymakers to try to juice the market, thus creating a more generally optimistic economic outlook, which may encourage spending and investment, thus restarting the stalled economy, in a replay of the virtuous circle that took hold during the nineties. It's hard to imagine a more explicit white flag of surrender to that temptation than a tax cut designed to encourage people to run out and buy dividend-bearing stocks.

Now, as ICBW readers know, I'm not exactly thrilled about measures that increase ordinary investors' naive faith in the stock market as the repository of choice for their entire life savings. And today's valuations don't exactly suggest an investor so consumed with revulsion at the thought of taking a chance on equities as to need an incentive in that direction from Uncle Sam. Under these conditions, one might have thought that the authorities would hesitate before attempting to reinflate the disastrous bubble that popped (or rather, began its gradual, long-term and still-incomplete collapse) only three years ago. It appears, though, that one would thereby be placing a little too much faith in the responsible sobriety of the current administration's economic advisors.

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