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MARKET BEAT

Aim of Tax Cuts: Boost Risk-Taking

Reduced capital gains and dividend levies would encourage stock investing. But what if the bear market isn't over?

May 25, 2003|Tom Petruno | Times Staff Writer

Tax policy has always been a favorite government tool to try to change behavior -- of consumers, investors, companies and the government itself.

The tax-cut bill that Congress sent to President Bush on Friday has the potential to modify the behavior of all of those constituencies, perhaps in significant fashion over time.

There is little question about the bill's anticipated effects on consumers and government. The former are expected to spend more, and the latter is virtually certain to borrow more.

For investors and companies, however, the changes the bill may bring seem less obvious, partly because it is unclear exactly what Congress was trying to do with that part of the tax law.

When President Bush first proposed tax changes in January, the idea was to end federal taxation of company dividends entirely. The plan was presented as an issue of basic fairness, addressing the perennial Republican pet peeve of "double taxation": Companies pay tax on their gross profit, then shareholders pay tax on dividends paid out of net profit.

Bush also said the plan for a zero tax rate on dividends received by investors was about boosting the stock market and stoking job creation, but many economists saw it principally as a major tax-reform measure. "What does this have to do with fiscal stimulus?" William Dudley, an economist at brokerage Goldman Sachs & Co. in New York, asked at the time.

When Congress took up the debate over Bush's proposal, the House was willing to go along but some senators deemed as too expensive the cost to the Treasury of permanently eliminating dividend taxes. So a compromise had to be struck to get a bill to Bush.

The result is that investors now will face a maximum 15% tax rate on dividend income and on long-term capital gains, down from 38.6% and 20%, respectively. The 15% rate -- good for at least five years -- is the lowest investors have paid on either dividends or capital gains since before World War II.

Any tax on dividends received means that some form of double-taxation still exists. Thus, the tax reform that Bush initially sought is only partly achieved by what Congress sent him.

Nonetheless, investors have been given a gift in the form of lower tax rates on both dividends and capital gains.

So what behavior does the government now expect of investors? Simply put, it must expect them to take more risk.

In theory, the sharp decline in investment tax rates should make investors feel less reluctant to put fresh cash into the stock market. If that happens, it could make more capital available to companies, which could boost the economy -- depending, that is, on how corporate managers would put that capital to work.

Lower tax rates on dividends and capital gains "will have a profoundly positive effect on job creation," Treasury Secretary John Snow said Thursday in his official statement about the legislation.

The stock market has staged a strong rally over the last two months, lifting the blue-chip Standard & Poor's 500 index 16.5% and the Nasdaq composite index 18.8% since March 11, though they both declined modestly last week.

For the wobbly economy to strengthen in the second half of the year, many Wall Street pros believe it's crucial that share prices continue to advance, because that should help lift consumer and business confidence.

Yet millions of investors remain skittish about stocks after the losses they suffered over the last three years, and given the corporate and brokerage scandals that have been all too prevalent.

"What you really need is to get people interested in the stock market again -- get people to take risks again" with their money, said Dan Laufenberg, chief economist at American Express Financial Corp. in Minneapolis.

Robert Morris, chief investment officer at mutual fund firm Lord Abbett & Co. in Jersey City, N.J., put it more bluntly: "The stock market is where investors have to overcome their fear and loathing."

Reducing the Risk

By cutting tax rates, the government is lessening some of the risk involved in betting on stocks. If you bet correctly, your reward will be higher than it would have been without the tax changes.

Combined with the monetary policy of the Federal Reserve -- which already has slashed short-term interest rates and yields on high-quality bonds to their lowest levels in a generation -- the Bush administration is sending investors a message that it could never say out loud, but which goes something like this:

"If you want to earn anything more than paltry returns on your savings, you must forget about money market funds and Treasury bonds and consider buying stocks."

That message is almost certainly falling on fewer deaf ears than it would have, say, a year ago.

"Investors' impatience is growing with the lack of return on [capital] parked in cash," said Liz Ann Sonders, chief investment strategist at brokerage Charles Schwab Corp. in New York.

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