What's Your Take on Dividend Taxation?

President Bush touts his idea to eliminatethe tax on common stock dividends wheneverhe discusses his new budget proposals.He presents the idea as eliminating "doubletaxation of dividends," taxed first at the corporatelevel and then at the individual level. This proposalhas drawn fervent support andheated opposition from both ends ofthe political spectrum. Most of WallStreet is singing its praise, while manyDemocrats frown on its apparent cateringto the rich. But what exactly is theproposed elimination all about and whatdoes it mean for physician-investors?

CORPORATE CONNIVING

Under normal circumstances, UScorporations are expected to payincome taxes on their earnings, just asindividuals do. In reality, as recentaccounting controversies have demonstrated,many US corporations payno taxes to Uncle Sam at all.

Using depreciation and other legitimatecharges against earnings, somecompanies have used elaborate strategiesdesigned to make sure they neverpay a dime in taxes. The cable companieshave done that for years. By making suredeductions exceeded income, cleverly managedcompanies instead could use those funds to buymore cable systems or other assets.

CASH FLOW GAMES

The name of the game was cash flow, notreported earnings. Cash flow is what pays offdebt or allows you to expand. If you could convinceyour shareholders that they should payattention to the assets you were accumulatingand not to the profitsyou were reporting whenvaluing your stock, youcould continue buyingmore assets. This methodwas a perfectly validway to manage a companyif you were in anindustry, like the cablebusiness, in which dailytransactions made itquite clear what theassets would fetch onthe open market if youwanted to sell them.

ASSETS MOVED ABROAD

Some corporations have chosen todomicile themselves outside theUnited States, purposely to evade UStaxes. Others move their profits tounits outside the United States, wheretax rates are lower. They do that by shipping outraw materials or intellectual property (eg,designs) from the United States and then manufacturingand assembling finished goods elsewhere.If the company sells globally, then goodsmanufactured abroad may never touch theUnited States or be taxed here.

In recent years, some companies reportedhuge profits and paid no taxes whatsoever.Chevron, Colgate-Palmolive, General Motors(GM), MCI-WorldCom, PepsiCo,and Pfizer are just a handful of themany that not only avoided payingany taxes, but actually receivedrefunds from the Treasury,despite reporting hundreds of millionsof dollars in profits.

DECLINE OF THE DIVIDENDS

In decades past, companieswere esteemed for paying dividends.When you bought a stock,you would participate in thegrowth of the company's earningsvia both stock price appreciationand, hopefully, the company's dividends.

In the past 20 years, particularly when interestrates were above 15%, the corporate financecrowd decided that rapid growth companieswere better served using internally generatedfunds to accelerate their own growth rather thanborrowing money to build new factories, opennew stores, pay for research, etc. Dividendsbecame much less popular and much less importantonce individuals realized they were onlypaying a 20% tax on capital gains if they soldappreciated stock, even as their regularincome tax rate of 37% wasapplied to dividends received bythose in the top tax bracket.

If you look carefully, you will seethat most companies that pay largedividends are utilities or older, moremature companies that no longerneed the cash to grow. They are competingwith municipal bonds (munis)and treasury securities to attract yourattention. The appeal of munis is thatthe interest you receive is not taxed atthe federal level.

STATES' BUDGET STRUGGLES

Right now, many states arestruggling to balance their budgets.They have been thrown into deficitdue to reduced money flowing fromWashington and from sharply reducedtax receipts due to the stagnanteconomy. The removal of thetax on dividends could well put thestates into an even more precariousposition. They will have to pay higherinterest rates to attract investors.

Given the choice between astock like GM paying a 5.8% dividendand a muni with a similaryield, you're better off with the GMstock. In the case of the muni, youhave very little likelihood of capitalappreciation, since interest rates arecurrently at 40-year lows. You willonly collect the interest as timepasses. In the case of GM, eventuallythe recession will end and theprospects of the automakers willimprove. You should eventuallyenjoy a capital gain on your investment,and while you wait, you willreceive a 5.8% return, made all themore juicy if you don't have to paytaxes on it if Bush prevails and thelaw is changed to benefit dividends.

OTHER TAX-FREE TOOLS

By the way, some other corporatefunds already carry tax perks.The huge amount of investmentfunds now held in foundations,nonprofit organizations, Roth IRAs,etc, are not taxed twice. In fact, theyaren't taxed at all.

Taxes on earnings in pensionplans and 401(k) plans are not paiduntil the money is withdrawn fromthe plan, when you are presumablyretired and your tax rate is lower. Inthe meanwhile, it compounds tax-free.Roth IRA contributions aremade with after-tax dollars. Youdon't pay further taxes when themoney is withdrawn either, so it,too, accumulates tax-free.

WHERE THE MONEY GOES

According to numbers compiledby the Century Foundation, of the$42 billion of estimated costs to thefederal government for removingthe tax on dividends for individuals,$10 billion would benefit thoseearning above $1 million, and $12billion would benefit those earningmore than $200,000 per year. Thishigh-income group is not likely tochange its spending patterns andtherefore stimulate the economy,which is Bush's main claim as towhy this change should be made.

While altering the law mightencourage corporations to pay moreattention to their dividends, verylow present interest rates mightaccomplish the same purpose. Ifyou can finance a new store at 4%or so with a mortgage, the old argumentabout using that cash to fundyour growth is far less persuasive.

Joan E. Lappin is thefounder and president ofGramercy Capital ManagementCorp, a registeredinvestment advisor.She will be speakingon "Oil,Vinegar, andthe Middle East" onApril 22, 2003, at theSociety for the Investigationof RecurringEvents, at the PrincetonClub in NYC. Call ifyou would like to attend.She welcomes questionsor comments at 212-935-6909 or jlappin@gramercycapital.com.