Everybody wants in on dividend tax cut
By Laura Bruce • Bankrate.com

The proposal to cut or eliminate taxes on dividends might be popular with the stock market crowd, but other financial industries are quickly lining up to ask, where's ours?

However, they might not have much to worry about as legislators dicker over whether the country can afford President Bush's proposal to eliminate taxes on stock dividends.

Proponents argue that dividends now are double-taxed. Corporations pay tax on the profit they earn and then pass some of the profit on to investors in the form of a dividend, which is then taxed again.

But opponents point to the war and an ever-ballooning budget deficit as reasons to be wary of enacting such a large tax cut at this time.

And representatives of other financial industries that offer products popular with conservative investors worry that the lure of tax-free dividends would entice customers to siphon money out of savings accounts, money markets, certificates of deposit and annuities.

They want the government to even the playing field by making interest paid on deposit products and dividends paid on annuities tax-free also.

Tipping the balance of earnings power
"A dividend tax cut without a tax cut on interest would bias the products," says Keith Leggett, senior economist at the American Bankers Association, explaining that it would improve the risk vs. return ratio of stocks vs. deposits, so it would cause some substitution to take place.

"Exempting interest from taxes will attract more deposits, raise the return and make these investments more attractive to consumers."

Jack Dolan, spokesman for the American Council of Life Insurers, says making deposit products more attractive puts annuities at a disadvantage.

"Equal treatment is what we're interested in."

Federal Reserve Board chairman Alan Greenspan has also weighed in. Greenspan favors eliminating the double taxation of dividends but says it could hurt local governments that sell bonds to pay debt as it might make those investments less attractive.

Some local officials have speculated that they might have to raise interest rates on municipal bonds to make them competitive with tax-free dividends. Municipal-bond interest already is exempt from federal tax.

While some politicians say they want to pass the tax cut but they're concerned about balancing the budget, others have criticized the president's proposal as primarily benefiting the wealthy.

That's baloney, says 81-year old Flora Green of The Seniors Coalition in Springfield, Va.

"It's giving the impression that all seniors are of great wealth, and that's not true. I heard one congressman say it'll only give some people about $300. Well, that's a lot of money to me. My dividend pays for my Medigap insurance and my prescription needs, which, fortunately, at this point aren't excessive."

A boon for banks?
A dividend and interest tax cut could be a double bonus for many banks, since bank stocks often pay dividends. If dividends were tax-free, it could encourage more investors to buy bank stocks and, similarly, tax-free interest on deposit products could persuade more people to stash more cash in savings accounts and CDs.

"We're looking for support for two positive things," says Robert Davis, director of government relations at America's Community Bankers.

"Equity investment and interest-bearing vehicles; it makes sense to encourage savings across the board."

Bill Gooch, CEO of Community Bank of Elmhurst in Elmhurst, Ill., says he'd like to see a tax cut on deposit interest, but he doesn't think a tax cut on dividends alone would send his customers to Wall Street.

"It's going to take a while to get over what's happened to them in the stock market. We've done very little advertising, but people have been coming in here with their checks from Smith Barney and saying, 'I got hurt, I don't want to play this game anymore.'"

If the dividend tax cut does pass, be careful of shopping for stocks based solely on their dividend yield. A high dividend yield isn't always an attractive investment because the dividend yield increases as the price of the stock drops.

"Look for companies with a solid history of paying and increasing dividends. Good dividend-paying stocks provide an excellent source of retirement income and an income stream that grows over time," according to Bankrate.com financial analyst Greg McBride.

If there's not enough room in the budget to eliminate the tax on stock dividends, it's possible a partial cut could pass muster. Prior to 1986, the first $200 of dividend income was excluded from taxation. A heftier version of that, but short of a full exclusion, might appease a greater number of politicians.