Jewish World Review Jan. 16, 2002 / 13 Teves, 5763

David R. Kotok

David R. Kotok
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Consumer Reports


Bush plan and tax-free bonds: Impact negative.


http://www.NewsAndOpinion.com | If fully adopted, President Bush's dividend tax exemption proposal may have profound effects on the tax-free municipal bond market. A substantial realignment of Muni pricing relative to stocks is coming.

We can estimate the effects by measuring the present size of the municipal bond market and comparing it with the size of the prospective competing asset class of stocks. Our rough estimate follows.

The aggregate outstanding balance of municipal bonds today is about $1.8 trillion according to federal statistics. We will add a cushion for some additional issuance in 2003 and 2004. Let's guess that the total outstanding Muni balance will be nearly $2 trillion by the time the Bush Administration proposal is fully implemented and seasoned.

Let's assume that the President prevails in negotiations with Congress and that all dividends paid by all U.S. corporations are received without federal taxation if the corporation has already paid taxes on the earnings. Let's further assume that the managements of those corporations collectively change their behavior regarding dividends and start to reward their shareholders with increasing dividend payments.

For this exercise we will ignore the half of the economy that is driven by privately owned corporations and only focus on those firms whose shares trade on American stock exchanges. We will also assume that about half of American business is publicly owned. We will use the Bureau of Economic Analysis (BEA) estimates of economic profits as a guide to estimate what the dividend payouts will be in the post-Bush tax plan environment.

By the end of 2004 the U.S. economy should measure over $11 trillion in Gross Domestic Product. A normalized after-tax corporate profit share of that GDP would be about 5.6%. Let's round it to $600 billion in annual after-tax profits. We'll use BEA adjustments for inventories and capital consumption allowances. We'll assume that the payout ratio will be 50%; that is about the present S&P 500 payout ratio and consistent with estimates that aggregate U.S. businesses would retain about 50% of their economic profits to finance their future growth. 50% percent payout is a guess for the post-Bush plan era.

About half of those economic profits are earned by privately held companies. Their owners may have incentives to pay dividends but will be driven by their personal considerations. Those same owners currently operate their companies in a way to minimize taxation. We assume they will adjust their behavior for the tax code changes as they have always done in the past.

The other half of the profits are in the publicly traded companies. Using these assumptions we can estimate that they would be paying about $150 billion in annual dividends.

But not all shares of stock are held by taxpaying individuals. About half (actually 51%) are held by foreigners or in tax deferred or exempt accounts like 401k plans or pensions or charitable foundations. The Bush proposal doesn't change their status.

So when we are done with this exercise we get about $75 billion which will be paid in the form of tax exempt dividends to American individual taxpayers. That $75 billion of incremental tax-free income would be directed to many of the same folks who currently get their tax-free income from Munis.

About 1/4 of all Americans receive dividends either directly or indirectly through conduits like mutual funds. Not all recipients are in the upper tax brackets. Not all those folks own Munis. Not all would be interested in Munis after the Bush plan is adopted. BUT every Muni buyer should be interested in tax exempt stock dividends which is why money will bleed from bonds to stocks.

Let's assume that Munis are averaging a 4% yield at the benchmark 10-year maturity (5% at 30-years). That is close to present market pricing. That yield suggests that the demand for tax-free income in the United States is presently met by an asset class which will totals under $2 trillion.

Enter Bush's tax exempt dividend and this math changes.

If we use the 4% yield and the $75 billion annual tax exempt dividend number as an estimate, the Bush proposal has the effect of nearly doubling the aggregate asset class that provides Americans with the tax-free income they seek. We get this number by dividing the 4% yield into the $75 billion dividend estimate.

This amounts to a huge addition to supply. It should be viewed in the same way we would view a trillion new dollars of Muni issuance coming onto the market. It will depress existing bond prices since their yields will have to rise in order to absorb the supply.

The impact on present municipal bond prices will be negative. Monies will be allocated out of bonds and into stocks. Price adjustments will occur as dividend paying stocks rise and tax-free bond prices fall. Pricing references for munis will have to be re-established after the market has reached a new equilibrium. THIS COULD TAKE SEVERAL YEARS. It would be extremely dangerous for investors to assume that the pre-Bush pricing references for tax-free bonds will continue.

The impact on stocks would be less dramatic than Munis but still significant. The aggregate market value of all U.S. stocks is about $11 trillion. Some part of the additional valuation which results from the Bush tax plan would be added to the present $11 trillion as the prices of stocks rose during the time that reallocation of monies from bonds to stocks is underway.

Nearly doubling the asset class that provides tax-free income is the worst case scenario for Munis. It means a shift of several hundred billion out of bonds and into stocks. The relative price performance of Munis will be poor.

More likely than this worst case is that the President does not get all that he wants. There may be a limit on how much stock dividend income is tax exempt. Or there might be an agreement to tax dividends at capital gain rates instead of exempting them. The possible political compromises are many.

It is important to remember that tax-free municipal bonds are claims on state and local governments and have a terrific long term payment history. Stocks are of lower credit quality than bonds. That will mitigate some of the damage as monies shift from bonds to stocks.

We do not advise investors to panic and sell their Munis. There is a lot to be determined in the political process before the final impact on tax-free bonds will be known.

Investors should arrange their Muni portfolios in a defensive posture. They should not just be buying bonds in a "business-as-usual" mode. They should not do nothing and wait. These are uncertain times for Muni bond investors; any of the possible outcomes hurts Munis.

Of course the dynamics of the market could change things. There may be an increase in the demand for tax-free income as Muni bond prices fall and their yields rise; that would mitigate the damage done to the prices of outstanding Munis. Corporations may not change their behavior and dividend payouts may remain parsimonious; that would mean less competition from stocks. Other asset classes may be deemed more attractive. Changes in capital gains taxation may induce allocations elsewhere as gains become a more preferred goal than tax-free income.

The Bush proposal is so big that we really don't know how it will eventually effect all asset classes. We do know that it will hurt present municipal bond prices by some amount and help stock prices.

Stay tuned.



JWR contributor David R. Kotok is President and Chief Investment Officer of Cumberland Advisors, Inc. His articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, The Bond Buyer and numerous other publications. He can be seen on CNN, CNNfn and CNBC. Comment by clicking here.

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© 2002, David R. Kotok