Isle investors
laud tax cut

Bush's plan to eliminate taxes
on dividends should boost the
value of stocks, they say

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By Dave Segal
dsegal@starbulletin.com

Individual investors, who have seen rebates, tax cuts and interest rate reductions fail to rejuvenate their portfolios, may be getting some stimulus with staying power.

The $674 billion economic package that President Bush proposed today includes the elimination of dividend taxes that investors in past years had declared as ordinary income. The proposal was generally cheered by Hawaii stock experts, who said it promises to put more money in consumers' pockets, increase the value of dividend-paying stocks and give corporations more money to spend.

"I think this is profoundly huge," said Paul Loo, senior vice president of Honolulu's Morgan Stanley brokerage. "Growth isn't going to be 20 percent ... a year like it was from 1996 to 2000. It's going to be 8 to 10 percent because growth slows after a bubble bursts and people are shocked into sanity. They don't want companies without earnings. They want proven, established companies -- and those types of companies don't grow at 20 percent a year. They grow at 6 to 10 percent with an average of 8. And if you have a 4 percent yield on a stock and everyone now is willing to take 8 percent, you're halfway home with just the dividend."

Bank of Hawaii Senior Vice President Dave Zerfoss, who manages more than $7 billion in assets for the bank's investment department, anticipates that the abolition of the tax dividend probably will add 5 percent to 8 percent to the return of the stock market.

"It's the most significant thing to happen in the American capital-raising process in a very long time -- certainly since the capital gains tax rate was reduced some years ago," Zerfoss said. "I think it will be very good for the market over time and will encourage companies to take care of shareholders by giving them something much more tangible than the promise of reinvesting the money in other businesses that many companies have had a very checkered success over the years, or to be buying their own shares back."

Zerfoss calculates that a 4 percent dividend under the Bush plan would be the same as a current taxable yield of 7.3 percent for individuals in the highest federal and state tax brackets.

"Dividend checks you can't fake," he added. "There's no funny accounting there. It's cash in your pocket. If all of a sudden you don't have to pay any tax on it, it's a big difference. People start paying attention to dividends again."

Both Loo and Zerfoss said the elimination of dividend taxes also might gain the attention of Microsoft Corp.'s Bill Gates, whose company has $40 billion in cash, nearly $8 billion in annual income, no debt and is the only Dow Jones stock that doesn't pay a dividend.

"Let's say Microsoft decided today to pay a dividend of 4 percent and let's say it's tax free," Loo said. "Microsoft now only has to grow 4 percent to reach that 8 percent expectation. With everything coming down to earnings, that $54 selling stock is going to sell at $75."

Ethan Abbott, an investment representative for financial services firm Edward Jones in Kahala, said "the bottom line is that a cut in dividends is a wonderful thing for investors because it's going to fuel the market."

But as good as the elimination of the dividend tax sounds, though, it isn't for everyone.

State and local governments would suffer on two fronts:

>> Their tax revenues would be reduced because of the lost dividend taxes.

>> Their borrowing costs would increase because the yields they pay on their municipal bonds likely would have to be raised to remain competitive with dividend-paying stocks. That's because tax-exempt bonds would be less attractive since stock dividends also would be tax exempt.

Portfolio manager Barry Hyman, a vice president with Financial & Investment Management Group Ltd. in Wailuku, Maui, isn't sold on Bush's proposal.

He said there is no guarantee Bush's plan will work because it represents only a small portion of the economy.

Hyman said the domino effect that the Bush administration is counting on to trickle down through the economy is a "Pollyanna scenario."

"Equities as measured by the prices of the major U.S. stock market indexes are still overvalued," Hyman said. "Overvaluation tends to have a dampening effect on such a small stimulus. So there is no guarantee it will work. In light of this glass half full but half empty scenario, we believe high-income-paying stocks, convertibles and bonds are investors' best bets."

Democrats have argued that Bush's proposal would benefit mainly the wealthiest Americans, but Zerfoss said Bush is heading down the right track.

"If you have an American who is paying no taxes, why should that person be entitled to money?" Zerfoss said. "If 5 percent of the earners are paying 50 percent of the income taxes, why wouldn't they get the lion's share of the tax reduction?"