Why and How to Promote Dividends

Paul Haahr
5 January 2003

During the boom of the late 1990s, I was one of many people predicting that it would end in a bust. I also argued that we wouldn't see a stock market recovery again until after market-leading, successful companies started to pay dividends. While this is happening to a small degree, the big change I predict has not occurred. In particular, I was thinking about Microsoft and Cisco.

My reasoning was (and is) that the bubble was caused by a disconnect between the market value of stocks and the discounted future cash flows, both capital gains and dividends, and recovery can only occur after investors believe that market values of stocks are below the discounted future cash flows. Because stock prices are not showing any significant upward momentum, investors do not currently believe that capital gains are sufficient reason to invest; this causes a negative feedback cycle (stock prices remain low → no capital gains → no confidence in investing in stocks → stock prices remain low). To break the cycle, investors need a reason to get back into stocks, and payment of dividends is the only obvious reason.

Microsoft provides a particularly instructive, if extreme, example. Microsoft has over forty billion dollars in cash on hand and is adding to that at a rate of roughly ten billion dollars a year, after all is said and done. What are they going to do with that cash? In particular, what could they do with that cash which would cause their share price to go up? Stock buybacks, a favorite answer of the 1990s, are out of vogue right now, probably because CEOs and CFOs don't think of their own companies good investments for the companies' cash; this is not a good sign for investors. Acquisitions in cash are probably better, but could Microsoft acquire any company which would improve its profitability or margins?

On the other hand, Microsoft could start paying a dividend. Given that they have roughly five billion shares outstanding, an annual dividend of two dollars per share would be affordable for them; assuming profits continue to grow, they could still accumulate cash while paying such a dividend. Can you imagine the market's reaction if Microsoft announced a fifty-cent per share quarterly dividend?

The conventional argument that growth companies make against paying dividends is two-fold, with the two parts reinforcing each other: they can invest the money better than their shareholders and the tax structure -- full taxation of dividends and reduced taxation on capital gains -- favors them holding on to the money for the benefit of their shareholders, even if they have no immediate plans for it. Obviously, this is true for companies without large cash reserves or which are in cash-intensive expansions. But applying this argument to companies which have no obvious need for the cash is now getting in the way of a stock market recovery.

So, since I'm in favor of policies which help the markets, I should be in favor of the dividend tax cut proposals, because they reduce or eliminate the double taxation argument. But I'm not, because it introduces increased distortions into the market. In particular, there would become a relative disincentive to invest in dividend-paying stocks in tax-deferred accounts (e.g., 401(k)s), just as there currently is a disincentive to invest in tax-free municipal bonds in such accounts.

The right answer should be obvious: continue taxing dividends, yet let companies expense them as they do with all other cash outflows. This proposal has been made a couple of times in public, but rarely gets discussed in the political commentary. I think there are three reasons for this:

It's more expensive, in terms of tax revenue, than just a dividend tax cut.
It doesn't feel like a tax cut for voters, just a ``corporate tax cut,'' and thus has much less political appeal. (This is ironic, because, if you believe the double taxation argument, it is a tax cut that voters should feel.)
For a major change to corporate tax and accounting policies like this, CEOs would need to lobby for it. But I suspect CEOs are relatively unenthusiastic about such a change, because it would create strong pressure on them to stop accumulating large cash positions. And CEOs like the power and flexibility such cash gives them.

I think this is a case of needing to save capitalism from itself. Allowing the expensing of dividends would be better for the long term interests of companies, including their CEOs, and investors, but it's hard to see a way to get there given current interests.