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Wall St. Expected to Hail Investment Tax Cuts

Though less than expected, the reductions could make stocks more appealing, bolstering the market's nascent recovery.

May 22, 2003|Tom Petruno And Josh Friedman | Times Staff Writers

The tax-cut bill outline that House and Senate negotiators hammered out Wednesday would make owning stocks more attractive for Americans, though probably not to the degree many had hoped, Wall Street pros said.

"It isn't a panacea, but it's a modest plus for the markets," said Greg Valliere, managing director of Charles Schwab Corp.'s Washington Research Group.

Any benefit could be important in keeping alive the stock rally that has lifted blue-chip shares 15%, on average, since mid-March. The rebound has raised hopes that the three-year-long market decline, the worst since the 1930s, finally has run its course.

In turn, a continuing recovery in stock prices could be key to reviving business and consumer confidence, which could set the scene for a stronger economy, many analysts say.

In the outline of the congressional tax plan, gone is the idea of eliminating taxation of cash dividends received by shareholders -- the centerpiece of President Bush's tax package when unveiled earlier this year.

Instead, the bill would tax dividends at a 15% maximum rate, at least for the next five years. That still would be a substantial reduction for investors in the highest tax brackets, because dividend income now is taxed at ordinary rates that go as high as 38.6%.

The new maximum tax rate on long-term capital gains also would be 15%, down from the current 20%.

If passed by Congress and signed by Bush, the plan would instantly make the potential rewards of owning stocks more appealing, especially relative to money-market and bond interest rates that are the lowest in a generation.

Even without a tax cut, investors who believe the economy will get better later this year "ought to be increasing their asset allocation to stocks and cutting back on bonds," said Don Straszheim, head of economics firm Straszheim Global Advisors in Santa Monica.

The tax bill would add impetus to that shift, he said.

The market showed little change Wednesday as details of the bill were being negotiated. The Dow industrial average edged up 25.07 points to 8,516.43.

When introduced by the White House in January, the elimination of dividend taxation was presented as an idea that would boost the stock market by making shares more alluring, and boost the economy by giving investors more after-tax income to spend.

It also was aimed at correcting what critics have long said was unfair "double taxation" -- because corporate earnings are taxed, and then dividends that companies pay out of their net profit are taxed when received by investors.

On Wall Street, the original proposal was expected to make investors clamor for dividend income, pressuring companies either to raise their dividend payments or to initiate such payments if they had previously declined to make them.

But the Bush administration soon faced criticism that its plan would skew the U.S. Tax Code, and corporate behavior, too far in favor of dividend payments. Some analysts feared that companies, particularly in the technology field, might fail to retain enough earnings to fund long-term growth.

In response to critics, the Treasury Department proposed a plan that would have allowed companies to effectively give their shareholders a capital-gain tax cut over time even if management chose to retain earnings instead of paying dividends.

That idea "was way too complicated," said Robert Morris, chief investment officer at mutual fund firm Lord Abbett & Co. in Jersey City, N.J.

The tax cut proposal now on the table would be closer to the administration's original plan in terms of benefiting dividend-paying stocks -- which typically are those of older and larger companies -- because the tax rate reduction would be greater for dividend income than for capital gains.

But by taxing both dividends and capital gains at the same rate, Congress would avoid being seen to favor one or the other.

The reduction in the dividend tax rate would provide a new measure of respectability for a source of income that has long been viewed as interesting only to conservative older investors.

At St. Louis-based brokerage Edward Jones, one-fifth of the firm's 5 million customers receive more than $100 a year in taxable dividend income, principal Mike Esser said.

Under current law, an investor earning $500 a year in dividends and paying federal tax at a 30% marginal rate would keep $350 of that dividend income.

If the congressional outline becomes law, that investor would keep $425 of his dividend income.

Although investors who own stocks in tax-deferred retirement accounts would not benefit directly from a tax cut, over time they would gain if the tax plan lifts stock prices, Esser said.

"Whatever happens on this tax bill, it's going to be wonderful for the investor," he said.

Other analysts, however, noted that the market's direction will be determined by much more than changes in tax rates.

If the economy fails to rebound in the second half of the year, threatening the recovery in corporate earnings that began last year, investors could quickly sour on stocks, some warn.

Also, some investors may be wary of the sunset provision expected to be part of the tax cut. Congressional negotiators still were wrangling Wednesday on that issue, but tentatively the tax cuts were set to expire in 2008 or 2009.

However, Congress may find it much harder to take away the cuts after they're in place, Straszheim said. Wall Street would scream that by raising the rates again Congress would set the scene for a market dive.

"It's probably fair for people to conclude that Congress probably won't let rates go back up when the time comes," Straszheim said.

Still, "just as Congress can give, Congress can take away," Esser warned.

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