Proposed Tax Package Divides Investors

If you've been confused about where toinvest your money, especially in light of themarket and interest rate fluctuations inrecent years, the confusion may be worsening.Thanks to President Bush's recent proposal torepeal the tax on dividends, you may be wishingfor the confusion of the past. Althoughthe $670-billion, 10-year proposal hasyet to be picked apart by Congress, theimpact of a tax-free receipt of dividendshas already polarized some inthe financial community.

TODAY'S BUSINESS STAND

The thrust of the new tax plan is toend the double taxation of dividends,which has been called for by manyinvestors and tax advocates over theyears. Right now, corporations make aprofit and then get taxed on that profit.If the company distributes excessprofits to investors in the form of dividends,shareholders then have to payordinary income tax on the dividendsthey receive. Critics argue that theincome earned by the corporation iseffectively taxed twice—once when thecorporation receives it and again when the stockholderreceives the dividend. And they want tosee this double taxation eliminated.

TAX CUT OBJECTIVE

The elimination of tax dividends is intendedto provide an economic stimulus in 2 ways.First, it aims to put more money in the pocketsof investors through tax savings, which wouldencourage them to put more money into dividend-paying stocks. Of course, ifinvestors were to do this, they wouldultimately be putting more moneyinto the pockets of the markets.

Second, with the elimination of taxon dividends received from corporations,those corporations might feelmore compelled todistribute profits totheir shareholders.In short, corporationswould stopspending money unnecessarilyand payout higher dividends.

It's expected thatas more investorsreenter the equitymarkets, volatility should decrease,and this stability will enable corporationsto increase their spending onacquisitions and new capital investments. Inaddition to all of these benefits, this move isexpected to create more jobs.

PROPONENTS' RALLY CRY

The proponents of the plan feel that the taxcut on dividends would drive investors to dividend-paying stocks, drawing them away frommore speculative issues that pay no dividends.Right now, more than 65% of all public companiespay no dividends. However, as a result of thetax cut, companies will feel compelled to do so tomaintain a market for their stock.

In addition, the mutual fund industry willdesign funds that maximize dividend payoutsand minimize capital gains distributions. This iswhat happened in Canada, where dividends aretaxed at a much lower ratethan regular income. Thereshould also be a diminishinginvestment in variable annuitiesand other tax shelteredinvestments, because capitalgains, as well as dividends, arenot taxed when earned, but aretaxed at the regular incomerate when distributed.

The impact on tax-qualifiedplans such as 401(k) plans and IRAs may bestronger. Since dividends will be tax-free, butinterest income won't, it may be wise to placefixed-income and interest-bearing holdings insidetax-qualified plans. Equity investments may dobetter outside these plans (eg, in an account withlower turnover and higher dividends).In addition to dividendsbeing tax-free, capital gains will alsobe taxed at a lower rate.

WHAT THE CRITICS SAY

Despite being in its infancy, theBush proposal regarding dividendshas already drawn a great deal ofcriticism. Opponents claim that theBush approach won't help the vastmajority of investors and that itwon't really help corporate America,as intended.

On the individual investor side,they claim that about 50% of alldividends distributed avoid immediatetaxation already, since dividend-paying stocks are held in pensionplans, 401(k) plans, and IRAs.Furthermore, the dividends arethen taxed when distributed toinvestors from those plans, and thetax exemption wouldn't apply tothese distributions.

Another point made about thetax break is that it is supposed tohelp senior citizens who rely on dividendsfor income. According tothe Brookings/Urban Institute TaxPolicy Center, about 41% of thebenefits of a dividend exemptionwould go to those over age 65.Theyalso claim, though, that about 40%of those benefits going to the elderlyare aimed at those making over$200,000 a year, about 2.5% of thecountry's elderly population.Critics further claim that elderlypeople with incomes below$50,000, which is about 50% of thecountry's elderly population, wouldreceive only 13% of the tax cutintended for the elderly, and lessthan 6% of the total tax cut.

POSSIBLE PERSPECTIVE

Critics of the proposed tax cutsay that a new flood of moneyshould not go into the market. Theyalso argue that since the tax breakdoesn't really affect corporations,they may not be compelled to beginpaying higher dividends, the claimof the plan's proponents. Althoughit would have been optimal to givethe break to corporations, it wouldnot have been "salable" politically,according to James Abate, investmentdirector for Global AssetManagement, a division of UBS.

Although Congress hasn't dealtwith the tax cut yet—and it willcertainly change as it goes throughcongressional scrutiny—the argumentson both sides are quicklypolarizing the financial community.Both sides' arguments appear tocarry some weight, but the ultimatetest will be how investors react tothe tax cut. With more people thanever owning stocks, the reaction—and subsequent investment in themarkets—could be more dramaticthan expected.

Patrick J. Flanagan is a New Jersey-based registered

representative affiliated with First Montauk Securities, member NASD/SIPC. He welcomes

questions or comments at 800-969-0899. Any opinions expressed are the author's and do not necessarily

reflect the opinions of First Montauk Securities or its officers, directors, or affiliated registered

representatives.