Thursday, July 25, 2002
A very good article on the opinion pages of the Wall Street Journal: Stocks Are Still an Oasis. Part of the article is devoted to the proposition that stocks are a buy. I suspect the bottom is a bit lower, but we're getting close in price and time terms. But that's not what I think is interesting about the article.
The author makes the point that this bear market is partly about mal-investment (specifically in telecom) but in its recent down phase is about the honesty of corporate earnings. And one reason why we had the potential for a scandal about corporate earnings is that stocks don't pay dividends anymore. It used to be that the way you found out whether a company had stable earnings was from the dividend yield: if the stock had a reliable record of raising dividends regularly, and dividends were a substantial portion of corporate earnings, then you could be pretty confident in the reality of corporate earnings and their probable continuance into the future.
Nowadays, stocks don't pay dividends. During the bull market, companies retained earnings or spent them on buying back stock to create capital gains. Why did they do this? The major reason is the structure of our tax system. Dividends received are taxed as income whereas capital gains are taxed at a lower rate. Dividends paid are not deductible whereas interest paid is. So if a company pays dividends, it increases its own tax bill and that of its investors; if instead it borrows money to buy back stock, it pays less in taxes and so do its investors. So corporations behaved rationally: they stopped raising dividends, and new companies never started paying them (even when they became huge and had a very stable earnings record, as, for example, Microsoft).
The result is that investors are deprived of a valuable signal and a valuable discipline on management. Management can finesse a bad quarter's earnings with little negative impact if business recovers thereafter, but dividends send cash out the door, and management with be loathe to spend actual money they don't have. And as managers increasingly compensated themselves with stock options, they had a new powerful incentive both to prefer capital gains to dividends (options don't pay dividends) and to manipulate earnings to generate capital gains.
We badly need to restore a dividend-paying culture to corporate America. The preference for capital-gains is tax-driven and does not accord with good corporate governance. Investors bought into the current system as a philosophy because of the outsized capital gains during the bubble years. Now that the bubble has burst, we can sit down and try to fix this aspect of the system that is broken. But how?
One part of the solution is to properly account for stock options; if we did that (as I have argued before), corporations would increasingly compensate executives not with options but with stock grants, which would pay dividends. That would eliminate the perverse incentives that options create. But to really change things, we need to tackle the perverse incentives of the tax system.
Tax changes that would eliminate the perverse incentives against paying dividends would include making dividend payments deductible (putting them on a level playing field with interest payments), and raising the capital-gains tax rate (bringing capital gains taxes into line with taxes on dividends) or, alternatively, taxing dividends as capital gains.
Personally, I'd prefer to see a more widespread overhaul of our tax system, which would solve the problem of low dividends as a small side-effect. I will outline my preferred tax system in another post. But even within our current system, minor changes in corporate and individual income tax policy could make a big difference in improving corporate governance by restoring substantial dividend payouts and the discipline they bring.