Wall Street Takes a-Wait-and-See Stance On Tax Cuts on Dividends and Capital Gains
The Bush administration is banking that the package of $320 billion in tax cuts and $30 billion in aid to States that Congress passed on May 23 will translate into some tangible benefits to Wall Street and the U.S. economy. Treasury Secretary John Snow forecasts that the plan, which is about half the size of the President’s initial proposal, will "create and secure jobs" for millions.
The plan’s centerpiece and its mostly costly provision-- a five-year reduction in taxes on dividends and capital gains--is the focal point for investors. The new tax laws approved by Congress favor income from stock dividends over other types of investment income, and cut personal taxes on dividends by about two-thirds and taxes on capital gains by 25 percent. In arguing for the abolition of taxes on some dividends, the President has predicted that such measures will lift the stock market, which, in turn, will jump-start the economy. Whatever the eventual impact, Wall Street’s initial response to the news from Capitol Hill was restrained. The tax cuts failed to create any immediate fervor, and stocks rose slightly on the day’s news, but remained down for the week. It is worth noting that the big gainers on the day of Congress’s announcement were utility stocks, which pay some of the highest dividends in the market, and that the Dow Jones Utilities average gained 8.42 points or 3.6 percent.
The impact on your wallet
Simply stated, investors will keep more of the income they receive from stock dividends. The new legislation lowers the tax rate on dividends to 15 percent - previously dividends were taxed as ordinary income with rates as high as 38.6 percent. Tax on capital gains declines from 20 percent, for investments held for more than a year, to 15 percent. A taxpayer in the highest tax bracket now is able to keep 85 cents of every dividend dollar - compared with 61.4 cents previously. Interest payments on bonds will continue to be taxed as ordinary income.
What impact will the tax cuts have on the financial markets?
Many investment strategists believe that the new tax laws will bolster the existing trend towards higher dividend payouts and that these initiatives will have other significant effects on U.S. financial markets.
Here’s what the experts who predict positive results are saying:
- Generally speaking, lower taxes will make stocks more attractive than bonds;
- Because they will retain more of their investment income, investors may be willing to pay higher prices for stocks - especially for blue-chip companies with a solid dividend yield;
- In 2000, dividend yields sank to 1 percent of stock prices-- their lowest point ever-- but now they are on a sharp upswing, with the average company in the Standard & Poor’s 500-stock index paying a dividend that represents about 1.7 percent of its stock price;
- If the tax cuts, which are slated to expire in 2009, are made permanent, dividends are expected to rise substantially over time in response to investors’ increased appetite for pay-outs; and
- After the scandals of 2002, shareholders want to see higher dividends - proof positive that a company’s balance sheet is solid and its earnings are real.
Other more cautious Wall Street pundits are taking a wait-and-see approach, echoing a long-standing truism that the market wants permanency. They believe these new tax reductions will have limited impact on the overall market, unless investors believe that the 5-year tax-cut package has a good chance of becoming permanent. Others want to see if higher budget deficits will adversely affect the bond market and hobble the nation’s overall economic performance, before betting on the tax cuts to bolster the market.
Money managers predict that it will take a few months to see the extent to which shareholders respond to the advantages of the new law, as small investors, who typically move slower than professionals, take time to restructure their portfolios. As always, remember that investment strategy should be shaped by your specific needs and goals, and that professional investment counsel can help you to adjust your portfolio to meet changing times and circumstances.