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:

*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.