No, Virginia, Tax-Free Dividends Won't Boost Stocks July 2003 - M.L.M. Wall Street is aquiver over an expected boost to stocks from the reduced tax on dividends. But how exactly is this supposed to happen? Presumably some investors who held off buying stock when their dividends were taxed will now jump in and start buying -- all things other than dividend taxation being the same. Who are they? A few big players won't change their habits, because they don't pay any taxes in the first place: pension funds, endowments, foundations, other not-for-profit enterprises, and perhaps most important, individuals who own stock in 401(k) funds and other retirement plans. Altogether, these investors own an estimated two-thirds of all stock outstanding. Whatever reasons they had or now have for buying stock, a lower tax on dividends does not give them another one. So we have to hunt among the owners of the other one-third. There is one group of investors who do care about dividend taxation: executives of public corporations who control their corporations through large (though not necessarily majority) stock holdings. I'm referring not only to the Bill Gateses. Thousands of controlling stockholders of public corporations care about dividend taxation a lot. The reason is that they can legally extract cash from their corporations in only three ways: by selling some of their shares, increasing their salaries, or voting dividends. All three methods generate personal tax liabilities. As the taxes on dividends are reduced or eliminated, it's clear which of the three attracts additional attention. Microsoft itself has recently shown the way by declaring its first-ever dividend. Apart from their own corporations' dividends, however, controlling stockholders have the same relation to the general stock market as the whole tax-paying, stockholding public. So if we're looking for a market boost from lower dividend taxation, we have to turn to that public. What can dividends mean to the investing public today? Here are the numbers. The dividend on $100 invested in the S&P 500 index is $1.57 (based on the July 15 index close and the weighted dividends of the 500 stocks, which is $15.70.) Now suppose an investor's income tax rate is 30%. The tax on her $1.57 dividend would have been about 47 cents, leaving her $1.10 of spendable income for every $100 in stock value. To make this easy, let's assume the tax on dividends was eliminated completely. Our investor now keeps an additional 47 cents in dividends for each $100 in stock she owns. Is that a benefit? Well, it's better than keeping less. But the question is whether the additional 47 cents of income will send her out to buy more stock? To believe that, you have to believe that a 47-cent tail is going to wag a $100 dog. Here's why that's unlikely. It's the dog that worries investors today, not the tail. The wretch hasn't gained an ounce in almost six years. Investors who bought in six years ago are lucky if they are still worth the capital they invested. Investors who added $100 to the S&P 500 four years ago have barely $70 of it left today. The reality is that investors didn't then and don't now buy stock for the dividend yield, but for capital gains -- period. If those who bought four years ago are still holding on, it's not for the dividend, but only because they dream of seeing their $100 again -- which, incidentally, would require the market to rise by 40% from this point, and that's after this year's big advance. Those investors dream of recouping their $30, not an additional 47 cents. The longer their dream isn't realized, the more likely they will be to drop out, and a tax-free dividend won't hold them. Those who took their lumps and cashed out are hardly more likely to throw in another $100 now, simply because the dividend they get to keep rises by 47 cents. It's the same dream of making $30 -- well, maybe they'll settle for $25 -- that would have them reaching again for their checkbooks. But wouldn't increased dividend retention have some positive impact on stock prices, at least "at the margin?" I suppose it must, because so many smart people say so. For myself, changes "at the margin" don't propel me to act. If I'm told that lower water temperatures off Florida make the sea safer, because the concentration of sharks will be reduced, at least at the margin, I don't feel any greater urge to jump in. I'll stick with my advice: stay out of the water. Back to MLM Commentary