The Dividend Tax Cut and Interest Rates

On January 7th, 2003, the U.S. President George W. Bush announced a package of tax cuts with the hopes that, when implemented, the tax cuts will stimulate the currently slow U.S. economy. The centerpiece of the Bush plan is to eliminate the taxes investors pay on dividend income. Currently, any money an investor receives when a stock she owns pays a dividend to its investors is added to her total income at tax time. So dividend income is treated the same way, and is taxed at the same rate, as income from working. If the Bush plan becomes law, dividend income will no longer be added to an investor’s total income. As a result the dividends become exempt from taxation. The exact details of the plan are not currently known, because it has not been debated or passed by Congress yet. As well, there is some uncertainty as to how the government will define "dividend" and what exemptions, rules, and loopholes will be written into the law. For the purpose of this article, we will assume that the dividend tax cut will be wide ranging and cover most stocks when Congress passes it.

The Bush Administration hopes that by eliminating the dividend tax, investors will be encouraged to buy more stocks. This, they believe, will cause a rise in the value of the market. The main question is: where will investors find the money to buy more stocks? Incomes are not likely to increase a lot in the short-term. Thus, if investors are buying more stocks, they must, necessarily, be buying less of something else. It is likely that consumers will buy less of the good that is the closest substitute to stocks, and for most consumers that good is bonds.

Bonds are, in essence, a loan taken out by a government or corporation, with the promise to pay back, to holder of the bond, a fixed amount at a later date. Bonds are a close substitute for stocks, because the two goods share many attractive qualities. Both stocks and bonds tend to appreciate in value over time. Also, unlike investments like