A Dividend Divided

The dividend tax cut is supposed to benefit all stockholders, so why does it only help half of them?

Since President Bush gleefully signed legislation reducing dividend taxes on May 28, the stock markets have risen sharply. Undoubtedly, dividend-yielding stocks now seem more appealing than bonds or other fixed-income investments. In theory, the dividend tax reduction is supposed to benefit all investors by letting them keep more of their dividend income. The reduced taxes will also (theoretically) encourage companies to pay larger dividends to attract investors.

But those assumptions may be wrong, since it turns out that those who will actually receive a tax reduction on dividend income are a distinct minority of the shareholder nation.

According to the highly detailed Equity Ownership in America survey, jointly published by the Securities Industry Association and Investment Company Institute, about 84.3 million investors in 52.7 million U.S. households—about half the total—owned stocks as of January 2002.

But perhaps half of shareholders won’t get dividend tax relief, because they already avoid dividend taxes. These figures from the New York Stock Exchange break down holdings of corporate equities in the United States. As of the end of the third quarter of 2002, according to the NYSE, the total market capitalization of U.S. equities was $11 trillion.

Private pension funds (e.g., the General Motors pension fund) had $1.41 trillion in equities, while state and local pension funds held $937 billion—together 21.5 percent of total stock ownership. These funds are already shielded from dividend taxes.

According to the Investment Company Institute’s Fact Book, mutual funds in retirement accounts like 401(k)s hold $1.2 trillion in domestic equities—another 11 percent of the total that hasn’t been subject to dividend taxation and thus won’t receive any benefit from the recently enacted cut. (And this figure doesn’t even include fast-growing, tax-favored savings programs like the 529 college-saving plans, which have $18 billion in assets.)

Subtract the 11 percent of stocks owned by foreigners, and already more than 40 percent of U.S. stockholders aren’t taxed on dividends.

The percentage of stocks that won’t benefit may reach 50 percent when you count the holdings of nonprofit endowments and foundations. Gigantic pools of capital such as the Harvard University endowment ($18 billion at the end of Fiscal 2001) or the Bill & Melinda Gates Foundation ($33 billion) don’t pay dividend taxes now. According to the Foundation Center, in 2000, some 56,582 foundations had total assets of $486 billion. And the Chronicle of Higher Education reports that last year university endowments held $222 billion. A significant portion of those assets are likely in stocks.

So, who will benefit directly from the dividend tax reduction?

According to the Equity Ownership in America study, about 21 million households have individual stocks (including stock options) outside of employer-sponsored retirement plans, and 28.7 million households have stock mutual funds outside of employer-sponsored retirement plans. There’s a large overlap between these two pools. A household that owns individual stocks is highly likely to own mutual funds, too. But as this piece by Jonas Max Ferris in lucidly argues, because mutual funds take their fees out of taxable income—i.e., dividends—many mutual-fund shareholders will never see much gain from the dividend tax cut.

It’s not too much of a stretch to conclude that fewer than half of the U.S. households that own stocks—or less than one-quarter of all households—will receive meaningful dividend tax cuts. Of course, these figures are nothing to sneeze at. There are plenty of elderly Americans who rely on dividend income—you can see them at the annual meeting of any large utility company. And there are plenty of people with modest stock holdings—63 percent of individual stock holders have less than $50,000 in stock—who’ll be glad for a little sweetener.

But it’s not clear that the tax cut will do what supporters hope and actually increase dividends. Will the interests of a minority of shareholders motivate companies to pay larger dividends? On the whole, corporate management has been rather contemptuous of minority shareholders.

And the tax cut could backfire against the millions of Americans saving for their retirements through tax-advantaged programs. Since the income thrown off by dividends is worth more—at least to those who pay high income taxes—investors may be willing to pay more for stocks. (Boosting the market was one of the explicit motivations behind the move.) But the people who haven’t been paying taxes on the dividends they receive—which is to say the holders of most U.S. shares—will have to pay more for the same amount of dividend income. In other words, when your pension fund wants to buy shares in a dividend-paying company, it will need to pay a premium, since those who are benefiting from the dividend tax cut will have bid up the share price. Your fund—and you—will get less for your money.

President Bush and Congress have created a confusing dividend tax cut because they cut the dividend tax the wrong way. Making dividend payments tax-deductible for companies—and thus equalizing the tax treatment of interest payments and dividend payments—would have provided a direct incentive for companies to pay larger dividends and would have averted much of the accounting confusion. But that might have been viewed as an unwarranted sop to corporate America. The Republican Party usually makes no bones about behaving as if it is the legislative auxiliary of the Business Roundtable. Why, in a case when acting as a servant of corporate America would have been a good idea, did President Bush and Congress restrain themselves?