Wednesday, January 08, 2003

Final note on dividends (and a brief note on deficits)

The amount of mail I've received over my note on dividends has far exceeded the volume on any other topic. Why discuss the future of technology when we can rehash a tangled tax code, muddy macroeconomics, and dubious distortions?

I'm closing the book on this with this final post:

Firstly, the distortion from dividends is almost entirely on the supply side of the economy. Shareholders can get money out of their investments by either share buybacks or dividends. Buybacks are taxed as capital gains (usually a 20% tax rate) while dividends are taxed as income (about a 40% tax rate). This difference creates a distortion above and beyond the distortions we naturally get from any tax (and no, I do not support eliminating all taxes). Since firms should not be making dividend vs. buyback decisions for tax reasons, these two rates should be made the same. (I am told the plan currently calls for dividends to have a lower tax rate than capital gains, which fails to fix the problem and so is bad. I am also aware that the tax system for capital gains is complex and depends on time held etc, but we can only fix stupid laws one at a time. And finally yes, we could increase the capital gains tax to 40%, but this would quadruple the economic harm the capital gains tax creates, which would far outweigh any benefit from reducing the distortion caused by differential tax treatment).

This plan is not a gift to the rich. It will not result in a huge outflow of cash to wealthy shareholders, because companies (cough cough, Microsoft) can already do that by buying shares back and choose not to. As a matter of fact, this plan, like almost all supply side plans, will not be stimulative at all because it merely improves capital allocation and should add a few basis points to US annual productivity growth rates. That's worth $billions in 2020, and $0 now.

There are good reasons why governments should try to be fiscally stimulative -- Keynes's animal spirits and all that. There are also good reasons why governments should not try to be fiscally stimulative -- namely they've proven to be crap at it. States are crying now because they have no money and times are tough, but you did not see them building up serious rainy day funds when things were booming -- it's much funner to spend more and cut taxes. But whatever -- both sides have valid points.

This plan will also do nothing to boost the stock market. Firstly, I don't see what all the fuss over the market is about because the equity market and the real economy have been pretty unhinged now for about 7 years. Secondly, the market is not going up because stocks are still overvalued with respect to earnings (note: I am lousy at predicting markets). Thirdly, the real economy has been remarkably robust, mainly buoyed by consumer spending. This seems reasonable because the same overcapacity that's dried up business spending has also driven prices lower through more intense competition. The 6% unemployment rate is low by US historical standards, and a distant dream by international standards. While very unpleasant for those without a job, unemployment in the US is far from being in crises. We can revisit this if it hits 10%.

So long as the eventual tax rate on dividends is close to the capital gains rate, the most striking feature about this plan is how boring and sensible it is. So let's move onto something more exciting:

Deficits: Are They Bad? Firstly, there's a difference between real deficits and accounting deficits that's important to understand. I mentioned it a while ago. I'm too lazy to look up the numbers, but I know the US was still running surpluses a few months ago, and was running surpluses long before it was "officially" running surpluses. So there is less budget deficit than there appears.

But is a larger deficit bad? It depends on how much you think the suppliers of the money you're borrowing will care. If you think suppliers will not care -- i.e. they still think you're going to pay off your debt with no problems-- then a larger deficit does not matter much. If you think suppliers of money will freak out and raise the price of borrowing (through higher interest rates) then running a larger deficit is bad as it makes investment more expensive -- this is the Rob Rubin position, and Rob Rubin is a really really smart guy. Nobody knows how sensitive the supply of money is to deficits, but Really Big deficits, that grow, with no spending control in sight, definitely freak out lenders. On the other hand, productivity growth in the US economy is still dazzling and should remain strong for years to come. Or it could not. I don't know.


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