President Bush announced his latest economic stimulus plan on January 7,
2003. A central component of the plan was the elimination of the double
taxation of dividends. Under the current tax code, dividends are taxed
at the corporate level as earnings and again at the shareholder level as
income. The President has proposed that the payments to shareholders be
exempt from taxation. If this proposal were enacted, a new type of
tax-exempt income would be created.
We do not believe that the end of the
double tax on dividends will negatively affect the municipal market
substantially. We do not foresee investors selling municipal bonds to
buy stocks simply because stock dividends are tax-exempt. In our view,
stocks and bonds have distinct risk/return characteristics and are both
important components of a diversified portfolio.
Investors purchase municipal bonds
because of the dependability of income and security of principal that
they offer. The interest payments and the return of principal from a
municipal bond are virtually certain—barring default. As investors
have learned, stocks offer no guarantee of principal return or dividend
payment. A change in tax status does not change the risk element of
investments: A triple-A municipal bond is backed by the full taxing
power of the issuing entity, a corporate bond is backed by the assets of
the issuing company, and dividend payment is paid from the after-tax
earnings of the corporation. Municipal bonds are comparatively secure
investments, with a much lower default rate than their corporate
brethren. Investors will not necessarily want to assume increased credit
risk just because the tax status of dividends has changed. Also, unlike
equities, which are open-ended investments, municipals have a stated
final maturity that allows investors to match cash flows with expected
future liabilities. Finally, the current dividend yield on the S&P
500 index is an unimpressive 1.72% that, even on a tax-exempt basis, is
not competitive with the yields available on municipal bonds currently.
While we do not believe that the
exemption will result in significant under-performance by the municipal
market, it may affect municipals in other ways. There could be credit
implications as most states use the federal government’s definition of
taxable income for their income tax calculations. Exempting dividends at
the federal level may result in exemption at the state level as well,
decreasing state revenues just when many states are facing significant
budget deficits.
There may also be market implications.
Investor confidence could increase as dividend payments increase,
because while earnings can be manipulated, a cash dividend cannot. If
confidence improves and investors’ enthusiasm for equities increases,
a rally in equities could lead to some bond market weakness, but not
necessarily municipal-specific weakness.
Although the exemption of stock dividends
from taxation will produce an alternative source of tax-exempt income
for investors, the municipal market will still offer investors the more
secure and predictable source of tax-exempt income, in our opinion.
Since investor demand for safety of principal and reliability of income
is unlikely to abate, we expect that the municipal market will maintain
its relative value.
This
column is provided by Thomas McGlone, First Vice President-Investments,
Prudential Securities Incorporated, 302-227-7342. Additional information
on the securities discussed herein is available upon request. Securities
products and services are offered through Prudential Securities
Incorporated, a Prudential company. ©Prudential Securities
Incorporated, 2003, all rights reserved. One New York Plaza, New York,
NY 10292. We recommend that you obtain the advice of your Financial
Advisor regarding this or other investments.
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