SeekerBlog

John Rutledge at WSJ (subscriber only) argues the case for making the tax cuts permanent:

America is not competing for jobs with China. We are competing for capital. Double taxing dividend and capital gains income drives capital to China, where it earns higher after-tax returns. When that happens, American workers are left behind with falling productivity and uncompetitive companies.

Reducing or eliminating dividend and capital-gains tax rates keeps capital in America, where it makes workers productive and supports high incomes. Congress must act now to keep rates from increasing in 2008, by extending or eliminating dividend and capital gains taxes.

And summarizing key statistics since the 2003 tax cuts:

The 2003 cuts in both dividend and capital-gains tax rates was a substantial boost for the stock market and corporate boardrooms. The Dow Jones Industrial Average is up 32% since Dec. 31, 2002, one week before President Bush announced the 2003 tax cuts. The S&P 500 large-cap index is up 47%. Mid-caps are up 79%, and small-caps up 81%.

Overall, the value of U.S. equities increased $6 trillion (up 50% from $11.9 trillion to $17.9 trillion on Sept. 30, 2005) since the dividend tax cut first appeared in the headlines. Household net worth increased $12.1 trillion to $51.1 trillion over the same period, an increase of $40,631 for every person in America. These gains accrue to the 91 million Americans who own shares of stock directly or through mutual funds, and to more than 80 million private and government workers through their pension funds. Growth, profits, and investment spending also grew, and we have created 4.4 million jobs. Tax cuts were a major factor in producing these gains. . .

Rutledge outlines some of the cause-effect mechanisms relating the type and magnitude of investment-related tax cuts and the consequences:

Dividend and capital-gains tax cuts are not trickle-down economics as claimed by opponents. They work by jolting asset markets, stock prices, and capital spending, and by altering business decisions about capital structure, dividend payout and capital deployment.

In December 2002, I prepared a report for a White House working group detailing how the dividend tax cut would impact the U.S. stock market through two different channels 1) recapitalizing the stock market and 2) restructuring corporate balance sheets.

Tax cuts initially impact asset prices by making investors recapitalize, or revalue, the equities of existing companies to reflect higher after-tax returns relative to interest-bearing securities, tangible assets like land and collectibles, and foreign assets. The return gap — more than 100 basis points for the 2003 tax cuts — makes investors sell relatively low-return assets, driving their prices down, and buy relatively high-return assets, driving those prices up, until after-tax returns have been driven together again. My estimates showed an initial positive impact on equity values of $560 billion to $938 billion, or 6% to 10%.

The restructuring impact of tax cuts on stock prices plays out over several years but is potentially several times larger than the initial price impact. The 2003 tax cuts were larger for dividend income (from 38.6% to 15%), than for capital gains income (20% to 15%); tax rates on interest income were unchanged. The positive impact on a stock’s value will be greater the more profitable the company is, the greater percentage of equity rather than debt on its balance sheet, the greater its payout rate, and the greater its duration (a stock with a greater duration is more sensitive to changes in cost of capital).

In 2003, U.S. companies were poorly structured to benefit from the changes. Decades of high tax rates on dividends prompted managers to reinvest profits and hoard cash for acquisitions rather than pay out dividends regardless of the company’s prospects. Meanwhile, deductible interest payments had encouraged managers to finance companies with debt instead of equity, which reduced profits and increased bankruptcy risk. According to the American Shareholders Association, the number of S&P 500 companies paying dividends fell from 469 in 1980 to 351 in 2002. By 2002 the S&P 900 large- and mid-cap companies paid out just 53% of profits, and financed companies with only 27% equity and 73% debt.

Once tax rates were cut in 2003, managers quickly learned they could profit from lower tax rates by restructuring balance sheets. Companies like Nextel issued equity to buy back debt. Other companies, like Microsoft, initiated new dividends and cleaned out their cash hoards through one-time special dividends. Most increased dividend payout ratios: Dividend payments received by shareholders have doubled since the tax cuts.

As companies, one by one, made these changes, their equity values increased further. But changing capital structure takes time, one reason I believe equities will enjoy strong returns for years if tax rates remain low.