Taxation of Dividends and the Municipal Bond Market
|by Tom McGlone|
|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 certainbarring 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.
LETTERS From CAMP Rehoboth, Vol. 13, No. 1, February 7, 2003