Here is the closest I find to a formal economic argument from the man. In this WSJ Op-Ed, if my eyes catch the fine print correctly, Paulson argued that the Bush dividend tax cuts will add 5 to 20 percent value to the stock market. (Here is my source, though I cannot find a permalink. And here is my source’s critique of the idea, although on this screen my old eyes cannot read it.)
I’ve never understood the Paulson argument for two reasons. First, at least in theory paying dividends should lower the value of the firm, relative to capital gains, given the higher dividend tax rate at the time. Dividends would appear to shift around the form in which wealth is held, pulling it from one pocket to another, rather than increasing wealth. I am the first to admit the entire topic of why dividends are paid is poorly understood, but that uncertainty does not militate in favor of targeting dividends for early and primary tax cuts. I would sooner cut or abolish the corporate income tax, for instance.
Second, for any given level of government spending, the wealth effects of the dividend tax cut (if those effects exist in the first place) are a transfer to equity holders and from….? Well, that remains to be seen. Stay tuned for your forthcoming tax increase…Some of you, that is…
Addendum: I should make the broader point that this pick is probably very good news.
Talk to anyone and they’ll tell you about the many mistakes Bush has made in office, but this is one issue where I think he at least took a step in the right direction.
A low book value stock that doesn’t pay dividends isn’t much different from a baseball card. It’s just a piece of paper. Remember, those of you who had any finance courses, the good ‘ol Gordon Growth model? Back in 2000 when I was getting my undergrad degree in Finance it was such a joke to figure out what the price of a stock should be, according to the GG model. P/E ratios were almost always north of 40, and due to the double taxation companies weren’t paying dividends.
We didn’t plunge into a depression after the irrational exuberance of the late-90’s but the financial world did lose their heads a bit, and the hangover was still nasty for many out-of-work people.
You buy a stock to own a company†¦ but you buy a company because you want a piece of their action, a disincentive to pay dividends keeps investors from sharing in those profits. It corrupts stock market valuations, feeding speculation. Don’t get me wrong, I understand that valuation is a very subjective term†¦ but it’s a snowball effect.
If you remove the disincentive to do what profitable companies should do (which is repay their shareholders), then investors will demand that companies reward them for taking the financial risk they do. ‘Good’ companies will valued, and those companies who don’t make a profit will have less capital available, in which to run up their stock only to see it tank when everyone sells off and moves onto the next shiny piece of paper.
Well elminating the corporate income tax is not a politically feasable.
Cutting the tax on dividends should, in principle, raise the return to holding shares. Though, the shareholder doesn’t require that the company actually pay dividends, she should require it be theoretically able to distribute profits in some manner.
Put another way – Suppose I am currently indifferent between buying ACME Inc lock stock and barrel then sucking out all the profits or instead putting my money in bonds. Now the dividend tax is repealed. I am no longer indifferent. I would rather buy ACME and suck out all the profits. Thus the price of ACME must rise.
At the very least, dividends that the investor chooses to reinvest in the same stock should be tax exempt
That way you can invest in companies that pay them as a way to avoid accounting scandals (the saying on Wall Street is “you can’t fake Cash”) without taking income.
Do note, by the way, that companies often raise new money for their managers at the same time they are paying dividends. Easterbrook (AER 1984?) makes some progress on this issue but it remains a puzzle.
spencer wrote: “First, if you look at the data you find that for every dollar raised in the stock market coporate america pays out some two to three dollars in dividends” and “In general dividend payers are more mature firms”.
Isn’t that how it should be? Dividends compensate investors for risk and for the time value of their money, and (as you said), a company has to mature for years before it can pay them. Yes, to compensate those investors, successful companies will pay out much more in dividends than they raised in equity financing.
For the same reason, over 30 years a homeowner might pay the bank 2-3 times the original mortgage principal.
I am not saying it is or is not the way it is suppose to be.
The theory is that the dividend paid out by a mature slow growth firm will be reallocated to new, faster growth companies.
But in reality the money raised by new firms in the stock market only ammount to some 25% to 33% of the ammount paid out in dividends. the theory that cuting the dividend tax will
lead to higher investments assumes that this money flows back into investment rather then consumption and that just is not the case.
Some 66% to 75% of the money paid out in dividends goes into consumption, not reinvestment.
By the way jane Gault in the US economy some 82% of nonresidential fixed investment is done by corporations, another 7% by non-profits and only 11% by individuals and entities subject to the individual tax code. Given these ratios the Chicago school
belief does not seem to have much to do with the real world.
Patinator — you are right and it makes the entire more complex.
In my personal tax code I would eliminate the corporate tax
and treat all income the same. but in reality that is a nonstarter.
Less of this unfair taxation business please. Most people likely bought their stocks when taxes on investment income were heavier at a price which refelected that. A tax cut now is a freebie at the expense of other taxpayers.
By all means remove distortions in capital and funding structures, even takes steps to reduce the cost of capital if for some reasons it seems too high, but fairness isn’t really an issue.
Well maybe it is. Not everyone who owns shares pays the same tax. Those that don’t pay as much get a good deal because prices are held down by the squashed demand of those who do.
I agree with you spencer (and Tyler) that cutting corp taxes is a much more efficient way to do this. But I am still missing the bit about redirecting consumption to investment. The original article by Paulson actually says the opposite — it says the tax cuts will help improve retiree incomes i.e. more consumption!
Yes but is as important as stock options?
Jane Galt’s actual comment was:
“The Chicago answer is that paying dividends adds value to the economy and the company by discouraging managers from sitting on big piles of cash, which they ultimately usually seek some stupid use for.”
I don’t see where she says “dividend payments will be re-invested” or anything of the sort. In fact I don’t think this has much to say at all about what the payments are used for. The real point is that the money flows to stockholders instead of being wasted by managers.
This has been one of the most lucid discussions of dividends that I’ve ever come across. My hearty thanks to all of you out there enriching my life and filling my mind with theory anew. Believe me, where I live, hearing this sort of talk is like drinking water after a desert…
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