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Tax plan would be a major shift

Boon for Wall Street could be bane for states

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The elimination of taxes on corporate dividends, which President Bush proposed Tuesday, could provoke sweeping changes in the way companies raise money and Americans invest. It could make American corporations less likely to go broke in bad times while making it more expensive for states and cities to borrow money.

Wall Street could see a boom in fees as companies rush to issue preferred stock, a relatively obscure security that could become the most popular way for many companies to raise money. And it could encourage more companies to pay dividends.

For investors, the saving would be likely to accrue only to those who held their stocks in taxable accounts — as opposed to 401(k)s and Individual Retirement Accounts. That could make such retirement accounts less popular, or at a minimum make investors less likely to use them for their stock investments.

Bush's stimulus package is also expected to include aid for hard-pressed state and local governments, many of which face large budget deficits that otherwise must be eliminated by raising taxes or cutting spending. Either remedy would tend to offset any federal stimulus.

But the dividend plan could hurt those same state and local governments by raising their borrowing costs and reducing their tax revenues.

Individual investors seeking to minimize their taxes have long bought municipal bonds, issued by state and local governments, because they don't have to pay federal income tax on the interest, and often no state income tax either.

"The principal attraction of muni bonds is that the interest income is exempt," said Robert Willens, a tax analyst at Lehman Brothers. "If dividends were exempt, and you also had the potential of capital gains, some stocks would look a lot more attractive than muni bonds."

The existence of another investment offering tax-free income would probably mean that issuers of municipal bonds would have to pay higher interest rates when they borrowed money.

In addition, many state tax laws incorporate the federal law's definitions of taxable income, so a change in federal law would automatically stop those states from taxing dividend income. That would reduce state tax revenues unless the legislatures amended their laws.

Because stock dividends would become more attractive to investors, all interest income could become less attractive. Investors could thus demand higher rates on everything from savings accounts to corporate bonds and even Treasury bonds. But the impact would be relatively small and could be overwhelmed by other trends in the economy.

The proposed elimination of all taxes on dividends goes well beyond what had been expected as recently as last week and helped to send stock prices up Monday, with some of the largest gains coming among companies that pay relatively high dividends.

The Standard & Poor's index of 500 stocks, most of which pay dividends, rose 2.25 percent. The New York Stock Exchange utility index, which is dominated by companies that pay relatively high dividends, rose 5.55 percent. That was its best performance since Oct. 20, 1987, when stock prices rebounded after the 1987 crash.

The elimination of taxes on dividends would lead to lots of questions about details to prevent abuse. Current law allows corporations to pay a low tax rate on dividends they receive from other companies in which they have invested, a fact that led to a series of tax strategies that Congress legislated against by requiring that companies cannot get the lower tax rate unless they hold the stock for a certain period — up to two years in some cases.

"I expect these laws to have the various anti-abuse provisions in them, as they do now for corporations," said Robert Gordon, president of 21st Securities, which specializes in tax strategies for investors. "If they don't, there will be some great opportunities from this, but I can't believe the government will be that obtuse."

A related issue concerns capital gains and losses. "A lot will depend on how the proposal deals with extraordinary dividends," said David Hariton, a tax partner at the large New York law firm Sullivan & Cromwell, referring to dividends of at least 10 percent of a share's value.

He said that without rules to prevent it, "a shareholder could buy stock, receive a large tax-free dividend, and then sell the stock for a capital loss that offsets a capital gain" from another investment. Rules that prevent corporate buyers of stocks from doing such things "might have to be extended to the individual level," he said.

Dividends are defined as money paid to shareholders by companies from their profits. Shareholders include holders of common stocks and preferred stocks.

The investment advantages of common stocks that pay dividends would be increased, but not enough to alter the investment climate fundamentally. High-dividend stocks would be more attractive, but the most important investment criterion would continue to be the outlook for the company's profits, since a downturn could lead to a price decline that would more than offset the benefits of the dividend, whatever its tax status.

Preferred stocks, at their simplest level, promise the investor a certain payment every year, just as a bond does.

But the elimination of taxes on dividends would mean that individuals who bought preferred stock could get tax-free income with risks similar to those of investors who buy bonds in the same company. That would be likely to drive up the price of existing preferred shares while also leading many companies to sell new issues of preferred stock.

Willens of Lehman Brothers suggests that Wall Street might move to issue such products aggressively as zero-coupon preferred stock. Such a share might cost $25 now and pay no annual dividend, but be redeemable in eight years for $50. "Under new rules, that could be very popular, for purposes like funding college tuition," he said.

For companies, a movement to borrow less through the bond market while raising more cash from selling preferred stock would have the advantage of leaving them in a better position if they ran into hard times. Companies that are financially pressed can usually defer or eliminate dividend payments. But if they are unable to pay interest on loans, they can be forced into bankruptcy.

Companies would still no doubt want to borrow money, because interest payments would remain deductible from income in computing corporate taxes, while dividends would remain nondeductible. But if rates fall on preferred stock, as seems likely, there would no doubt be much more preferred stock sold.

Real estate investment trusts now avoid paying corporate income tax by distributing all or virtually all their income to shareholders, who are taxed on the income they receive.

Presumably, since income has not been taxed at the corporate level, it would still be taxed at the individual level, and thus make such investments less attractive compared with high-yielding stocks on which dividends would be tax-exempt. That could lead to declines in prices for such trusts. On Monday, however, the S&P REIT index rose 1.08 percent, a gain that was smaller than the overall market's.

The interplay of dividend taxation on retirement accounts could be important. Retirement accounts now collect income, whether from interest, dividends or capital gains, and pay no immediate taxes on it. Years later, when the owner of the account has retired, he or she pays individual income taxes on all the profits from the account.

If dividends become nontaxable, that would make owning stocks, or mutual funds that invest in stocks, less desirable for such accounts, simply because taxes would still be owed when the profits were distributed to the investor. That could be changed, to make dividends on retirement accounts not subject to eventual taxation, but keeping track of such dividends over the years would require large amounts of paperwork and make the tax laws even more complicated, not to mention the impact it would have on government revenues.

If retirement accounts do not benefit from the elimination of dividend taxes, however, that would mean that millions of Americans whose only investment in the stock market is through IRAs or 401(k) accounts would not benefit from the tax change.

In that case, some investors might choose to revamp their investments, leaving taxable bonds, and possibly stocks whose expected profits will come largely through capital gains, in retirement accounts, while shifting preferred stocks and high-dividend-paying stocks to ordinary taxable accounts.