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Business & Money

Energy experts debate the pros and cons of the Bush administration's proposal to eliminate the double taxation of dividends.
Fortnightly Magazine - January 15 2003

Double Taxation Repeal: Fire or Ice?



Energy experts debate the pros and cons of the Bush administration's proposal to eliminate the double taxation of dividends.

The repeal of the double taxation of the dividend has been argued unsuccessfully for years in Washington. But with a Republican-controlled Congress and an economy in need of a stimulus, it's an idea whose time may have come. [Editor's note: At press time, the Bush administration had not issued its policy on repeal of the double taxation of the dividend.]

Certainly, one might think that this is cause for celebration for electric utilities, which pay the biggest dividends. But there are potential pitfalls. Experts say repeal is not a slam-dunk for the industry.

Paul Donahue describes a "fire and ice" debate that's brewing throughout the industry. Donahue, a managing director of Global Power & Utility Capital Markets at investment bank Morgan Stanley, says, "Utilities and real estate investment trusts [REITs] might find that they have more competition, instead of rising to the top." A bigger question, Donahue says, is what might happen if tax relief leads big industrials or cyclical tech companies like Microsoft to start paying out larger dividends. Some believe utilities could lose their staple as the go-to income investment for widows, orphans, and the upcoming wave of retiring baby boomers looking for safe stocks, he says.

But Donahue says others argue that a change to the dividend tax policy that favors investors would probably benefit those companies that already pay dividends, and that it would probably take years for companies that don't pay dividends to feel enough pressure from shareholders to alter their dividend policies.

"[Of course], it is hard to believe that tax relief on dividends will result in diminished valuations of utilities," Donahue said. "At worst it is a neutral event, but more than likely a positive."

If utilities retain their appeal as the kings of the dividend after repeal of the tax, most analysts agree that the sheer number of baby boomers retiring and purchasing dividend stocks could push up utility valuations materially.

"[Furthermore], even on below trend operating earnings the payout ratio for the S&P today is 15 percentage points below long-term averages. Putting an average payout ratio on current earnings would actually result in among the highest dividend yields versus government bonds in about 30 years," says Morgan Stanley's chief U.S. Strategist, Steve Galbraith, in a report.

According to Standard & Poor's, 71 percent of the stocks in the S&P 500 currently pay dividends. Across all exchanges, only 39 percent of all equities pay dividends. Granted, about 81 percent of the S&P 500's market capitalization pays dividends, but that is down from 98 percent in 1980.

For its part, Morgan Stanley generally believes repeal would be a positive for the industry, but like many on Wall Street, the bank is still waiting to see the fine print before fully endorsing the policy. According to investment bank Williams Capital, the administration is examining the "potential benefits of various tax cuts schemes."

"Potential outcomes discussed are a reduction or