At first glance the much-ballyhooed elimination of the federal income tax on dividends wouldn’t appear to have much impact on the tax-deferred investments of qualified retirement plans.   However, as yesterday’s market reaction suggests, the move will likely have an impact on how the market values stocks – and ultimately how shareholders, including institutional investors, demand to be compensated for their investment.  

Less Lustrous?

Some commentators have already suggested that the elimination of taxes on dividend income will lessen the luster of tax-deferred investments such as 401(k)s in the minds of participants, although this ignores the impact of an employer match – and other advantages of employer-sponsored retirement plans.  

It may well put additional pressure on state and local governments – not only in terms of foregone tax revenues (many are based on the federal tax code, and would also exempt dividends from taxable income), but also in terms of the interest rates they might have to pay to raise capital.   Municipal bonds generally pay a lower interest rate than comparable debt investments, largely because interest paid on those investments is generally exempt from state and/or local taxes as well.

In any event, a growing focus on the availability of dividends is already in evidence.   A recent report in the New York Times noted that dividend announcements were higher last year than the year before (1,425 companies made such announcements, up from 1,326 the previous year).   That shift provided further evidence of the waning emphasis on stock buybacks in the aftermath of the 1990s bull market (see  Firms Turning to Dividends to Draw Investors ).

Jobless Claims

The administration will urge Congress to extend emergency jobless benefits, which expired last month (see Time  Running Out for Unemployment Benefits ).   Additionally, Bush will reportedly propose giving states a total of $3.6 billion for job retraining and support for at least 1.2 million unemployed workers.   The program would offer jobless workers up to $3,000 in Personal Re-employment Accounts to spend on job training, childcare, transportation, moving costs and other expenses incurred in looking for a job.

One investment class that will apparently not benefit from the dividend tax exemption – money market mutual funds.   Under current tax law distributions from those funds are considered dividends.   However, the president’s chief economist, Glenn Hubbard, said in a Dow Jones interview that the president will propose writing the tax law to make clear that such payments are considered interest income and are taxed accordingly.

Other elements of the reported $674 billion, 10-year economic stimulus package:

• tax breaks for companies and allowing write-offs of up to $75,000 on capital investment, a limit that would be adjusted to inflation, according to Reuters.
• an acceleration of cuts of income tax rates across brackets retroactive to January 1, 2003, instead of 2004 and 2006, as originally scheduled.
• Increase tax credits for families with children from $600 to $1,000 this year instead of in 2010 and decrease marriage penalty tax this year instead of in 2009.