Don't Kill Our Dividends

In May 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA), which reduced the tax rate on qualified corporate dividends and long-term capital gains to 15% (in most cases). Without an act of Congress, however, JGTRRA will not last beyond 2010.

The effects of the act have been the topic of much debate, but here are three facts to help you decide for yourself. Between January 2003 and December 2007:

  • Dividends paid by S&P 500 companies increased by 70%.
  • The average yield of the S&P increased to 1.89% from 1.61%.
  • Companies like Best Buy (NYSE: BBY  ) , Quest Diagnostics (NYSE: DGX  ) , and Republic Services (NYSE: RSG  ) began paying regular dividends.

Because JGTRRA reduced the dividend tax from the individual's ordinary income tax rate to a maximum of 15%, it lessened the adverse effects of "double taxation," where a corporation pays taxes on its earnings and then investors pay yet another tax on the distributed earnings. Now that the dividend tax has been reduced, corporations have been more willing to distribute dividends -- and investors have been more inclined to receive them.

Excuse me -- I believe that's my money
The act also sports a more ironic upside: It promotes a tremendous benefit of dividends, that of saving corporations from themselves.

You see, in a perfect world, corporate managers would carefully select the most profit-packed investment opportunities. When those are exhausted, responsible boards would dutifully return remaining cash to the owners of the business.

Guess what? OK, you don't need to guess: This isn't a perfect world. Wasteful, egomaniacal corporate spending is rampant. It's not that executives aren't trying. But lacking a strong incentive to return the cash to shareholders, optimistic CEOs waste your money chasing projects that don't work out.

How do we know? In their 2003 study, "Surprise! Higher Dividends = Higher Earnings Growth," Rob Arnott and Cliff Asness shattered the conventional wisdom pegging dividend stocks as slow and stodgy. Instead, they discovered that the highest yielders actually had the highest earnings growth over the next decade.

In other words, dividends magnify efficiency by relieving the pressure to overinvest.

Ouch, that hurts!
It's also important to understand just how much of an effect a repeal of JGTRRA could have on your bottom line. Consider the difference in the after-tax dividend returns if JGTRRA never existed:

Company

Total Dividends Received From 2003-Present

After-Tax Return With JGTRRA (15% Tax)

After-Tax Return Without JGTRRA (35% Tax)

Boeing (NYSE: BA  )

$1,849

$1,572

$1,202

ConocoPhillips (NYSE: COP  )

$1,267

$1,077

$824

BB&T (NYSE: BBT  )

$2,290

$1,946

$1,488

Lockheed Martin (NYSE: LMT  )

$1,318

$1,120

$856

*Assumes $10,000 worth of shares purchased on June 2, 2003, and no reinvestment.

As you can see, JGTRRA's lower tax saved dividend investors quite a bit of money in a short period of time ($458 for the BB&T investor!). Over 10 years or more, the difference in after-tax dollars would be even wider.

Give me your poor, your huddled masses ... and your dividends
One group of stocks that may prosper is foreign dividend payers. Their governments often withhold a portion of dividends paid now; some, but not all, can be offset on U.S. investors' tax returns. Ironically, a more draconian dividend tax policy would put foreign stocks with high withholdings on more equal footing for American investors, effectively raising their appeal.

Everything is going to be all right
After seeing the benefits JGTRRA has bestowed on income-sensitive investors, a repeal of the act would be painful indeed, and it would cause shareholder money to be wasted.

But it wouldn't be the end of the world. Dividend stocks will still outperform, even if that means they do it from the safety of an IRA.

Companies that choose to pay dividends are often out ahead in terms of corporate responsibility -- and stability. In fact, numerous academic studies have shown that dividend-paying stocks beat those that don't pay out anything. So, politics or not, they're a smart place to be.

In fact, they're helping subscribers to our Motley Fool Income Investor service beat the market. As a whole, Income Investor is topping the S&P 500 by seven percentage points. If you'd like to see what all the fuss is about, I invite you to pick up a free guest pass right here.

This article was originally published Feb. 29, 2008. It has been updated.

James Early and Todd Wenning get by with a little help from their dividends. Neither owns shares of any company mentioned. Republic Services and BB&T are Motley Fool Income Investor picks. Quest Diagnostics and Best Buy are Inside Value selections. Best Buy is a Stock Advisor pick. The Fool owns shares of Best Buy. The Fool's disclosure policy cannot be repealed, even by an act of Congress.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 20, 2008, at 9:19 AM, graeme3000 wrote:

    In Australia they have a system known as "franking credits", where (instead of paying a reduced tax rate on dividends) stockholders receive a tax credit with their dividends equal to the amount of tax that the company has already paid. Dividends are then taxed as ordinary income, but your tax is reduced by all of the tax credits that you have received. So there is never any double-taxation of dividends.

    It's fair and makes a lot of sense, why can't they do that here?

  • Report this Comment On September 21, 2008, at 10:51 PM, portlandoregon wrote:

    INTERESTING ARTICLE THOUGHT ID SHARE IT WITH ALL OF YOU.GET RID OF THE OVERHEAD

    Boeing arguments just don’t hold up under close scrutinyELI BERNIKER Published: September 17th, 2008 12:30 AMRe: “Long-term job security drives Boeing workers to strike” (Richard S. Davis Viewpoint, 9-14).

    Davis has swallowed Boeing management’s arguments about costs along with the economic clichés that are the current gospel in business. Thus, the Boeing offer coupled with its long-term plans to outsource much of the remaining work are the keys to remaining productive and competitive.

    In effect, Davis tells the workers to take what they are offered. Long-term job security is to be achieved via outsourcing. None of these generalities holds up to examination.

    Less than 15 percent of Boeing’s costs are labor, and that includes many people who are not involved in touch work – i.e. making, moving and assembling parts into aircraft along with the engineering design of the aircraft, its maintenance, the manufacturing processes and quality standards. Such actual productive labor is much less than 15 percent.

    The biggest cost is “overhead.” Back in 1997, it was charged at 490 percent of direct labor and growing. It is always growing.

    Over the last 25 years, Boeing has had a stream of management initiatives intended to improve efficiency. All shared two characteristics.

    • “We do it to them” – “them” being direct labor in manufacturing or engineering. “We are OK, and they are the problem.”

    • No matter what the initiative, it always increased the ratio of chiefs to Indians. That’s overhead growing. By the way, the automotive companies are no better in that respect.

    What is overhead? For the most part, it is the cost of distrust. Because the company does not trust its employees, it builds many layers of supervision and management to control. Since nonunion employees are “totemed,” all remain fearful about their job security. Since there can never be enough control, layers of management are piled on.

    Some of that overhead is the cost of maintaining 147 metrics of performance in just the 737 manufacturing operation. Overhead keeps growing, justified by the need to control costs, even when the costs of control exceed any plausible estimates of the benefits of control. Thus, for every dollar in wages, there are five more to administer their work.

    Davis claims that outsourcing is a necessary component of Boeing’s strategy to remain competitive and not just the current fad from Wall Street. Let’s look at that more carefully.

    Why is Airbus a competitor? The Boeing answer is because it was subsidized by the European governments, thus allowing it to cut prices.

    That is the wrong answer. Airbus was certainly subsidized, but not to cut prices. The European governments made very clear that they wanted to preserve those high-tech jobs for European workers.

    What was Boeing’s response? Ron Woodward laid off 22,000 workers followed by Alan Mullaly laying off an additional 10,000 among a continuing stream of smaller layoffs. So Boeing’s answer to Airbus was to eliminate thousands of years of competitive advantage encoded in the skills and talents of its workers.

    When there was the dramatic turnaround in 1996, it was estimated that the average experience level of the 737 assembly workers went from 10 years to three years as employees moved up to better jobs that they had to learn. The aircraft may be commoditized but the skills required to build a quality, safe and beautiful bird are complex and only mastered with years of experience.

    Boeing claims that outsourcing will keep it competitive, that it wants to get out of making parts and reduce assembly work by outsourcing. It is a great system integrator and that will be its long-term strategic competitive advantage. So it outsources more and more of its engineering and manufacturing work.

    What is a company that is only a systems integrating company? Basically, it is an all-overhead company. What value is it adding that China, Japan, and India cannot readily duplicate? It is hard to imagine a more dysfunctional long-term strategy or one better designed to reduce Boeing’s competitive advantage. It is literally training and tooling its competition.

    So, we, as a community, should support the Boeing strikers. They are defending the jobs that sustain a major part of our state economy, and they are defending the long-term competitive advantage of Boeing for the benefit of shareholders and our community.

    The skills being displaced and destroyed by outsourcing are crucial to our ability to defend our country. Enough outsourcing and the Air Force will have to go overseas for its prototypes and airplanes.

    Eli Berniker of Puyallup is a professor of business at Pacific Lutheran

  • Report this Comment On September 22, 2008, at 2:29 PM, Sarvant wrote:

    Well, it was the dividends that created this whole mess and some people knew about it. If you want to know how and why, and why now? Read:

    http://managementchitchat.blogspot.com/2008/09/wall-street-m...

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