| James Jeffords | ||||||
Washington was in a tizzy last month after the sudden defection from the Republican party of senator James Jeffords of Vermont. Jeffords’ historic move tipped control of an evenly divided US Senate to the Democrats and it came within a whisker of changing the fate of the Bush administration’s tax proposals. But Jeffords decided to stay in the Republican fold for a few more days until Congress could finish work on that all-important bill. Big bucks had been riding on the outcome for Wall Street.
This political shocker came on the heels of the recent run-up in share prices. Last year’s bubble, it seems, really hadn’t burst after all, but transformed itself instead into some sort of living, breathing organism. The thing apparently was just exhaling when stocks went skidding in February and March. Now the question is: what has it been breathing in?
Share prices have defied old measures of value – P/E ratios, dividend discount models and the like – for years. And traders now talk openly about a Greenspan put – speculating that Federal Reserve chairman Alan Greenspan won’t allow the Nasdaq Composite index to sink below 1600. “He’s thinking of his legacy,” one US fund manager tells Euromoney. But surely that can’t entirely explain Wall Street’s latest levitations, even if it’s true.
One reason could lie deeply buried in president George W Bush’s tax programme. Tax scholars gathered last month at Washington’s American Enterprise Institute, a magnet for Republican thinkers, to debate whether or not cutting the highest personal tax rate – from 39.6% to 33% – would have any effect on stock prices. “No way,” would have been the answer 15 years ago. But evidence is starting to pile up that the president’s plan to do exactly that might indeed pump up share prices.
The old view has powerful support. Laurence Summers, secretary of the treasury at the end of the Clinton administration and now president of Harvard University, presented evidence in a 1985 paper with James Poterba that companies will issue shares to buy new machines whenever Tobin’s Q – the ratio of the firm’s market cap to the book value of its assets – exceeds one. Companies will spend more on investments, the argument goes, when the government cuts taxes on dividends. And that prevents share prices from going up.
But there has been a string of new studies suggesting that companies use retained earnings – not the stock market – to finance those additional – that is, marginal – investments. That would leave room for stock prices to go up if the government cuts tax rates on dividends and the president’s proposal would cut the top marginal tax rate by about 20%.
The US, in effect, taxes dividends twice: first as corporate earnings and then through individuals’ income tax. This stacks the deck in favour of borrowing by corporations and also discourages many businesses from incorporating. Partnerships and other legal structures can be much more efficient from a tax standpoint. Washington also taxes capital gains at considerably lower rates than dividends, at least for investors in the upper brackets. Dividends, not surprisingly, yield only about 1% of the typical investment in US stocks today.
“Ideally, we would have a tax system that is completely neutral,” says Peter Wallison, a prominent Washington attorney and resident fellow at the American Enterprise Institute. Wallison believes that reduced share prices resulting from dividend taxation hold down corporate dividends and increase the reliance on retained earnings.
“It penalizes new ventures by established corporations because new ventures don’t have substantial cashflows,” he continues. “We should reduce taxes on dividends if we want to increase new ventures, competition, innovation and employment.”
These decisions by corporations, of course, add up and then can show up in the performance of the US economy. Eric Engen, chief of the Federal Reserve’s flow of funds section, told the AEI meeting that the Bush proposal to cut tax rates would result in increased saving and increased investment by businesses. “That’s going to tend to lower interest rates in general,” he pointed out. Engen, however, was not appearing as a representative of the Federal Reserve Board and the views that he expressed were his own.
Engen also expects that the cuts would boost growth, though not by a lot. He concluded in a joint paper with Jonathan Skinner of Dartmouth College that a 5% cut in the tax rate would lead to a quarter-point increase in growth for the US economy.
What does all of this mean for stock-pickers? High-dividend shares seem to be the safest bet, but the new tax capitalization view suggests that all publicly-traded stocks might rise, provided of course they have positive earnings.
Tax cuts might even help dot coms and companies like them, at least to the extent that investors are pricing expected future earnings. But this body of research, so far, says nothing about their prospects.
Deen Kemsley, a professor at Columbia University Business School in New York and a leading researcher in this area. believes that the evidence is not definitive. “The teeter-totter has definitely shifted in the direction of the tax capitalization view and we should take it seriously in our debates about tax policy,” he observes.
The view from Wall Street, however, is palpably euphoric. “The Bush tax plan is strictly an old-fashioned Keynesian stimulus plan that should be very beneficial to stock prices down the road,” says Cary Leahey, a senior economist at Deutsche Bank in New York. Leahey looks for the bill to increase consumer purchasing power on the order of about $40 billion at an annual rate by the end of the year and perhaps by as early as August or September.
“That could lift growth in the fourth quarter by as much as one percentage point,” Leahey continues. “It will be a one-two combination of the biggest tax cut in the US since Ronald Reagan took office 20 years ago and also the most aggressive Fed easing in at least 15 years.”
