President Bush has proposed legislation that would eliminate the taxation of dividend income for individual owners of common stocks. We do not recommend that investors take any action at this point in anticipation what Congress might approve. Many aspects of the proposal have already been altered. Whatever new law survives the legislative process will very likely look much different from what has been proposed.

While the simple elimination of taxes on dividends sounds simple, what has been proposed is in fact complex. Dividends are taxed first as income to corporations; the remainder that is passed on to individual shareholders is currently taxed again at ordinary income tax rates if held in a taxable account. The proposal would eliminate double taxation at the individual level. However, dividends would be tax exempt only to the extent that the company had paid corporate taxes. This information would have to be provided to shareholders, creating another reporting burden. In addition, because the goal is to ensure that all corporate earnings are taxed only once, the plan also includes a capital gains tax break for shareholders of companies that pay the corporate levy on income but retain their earnings in lieu of paying a dividend. Thus with every dividend declared the taxpayer would have to track a new cost basis adjustment that would reduce the capital gain tax bite when the shares were eventually sold.

Investors would confront additional implications. Dividend income from Real Estate Investment Trusts (REITs), for example would not be exempt from taxation, since REITs do not pay corporate income taxes if they meet minimum distribution and other requirements. The jury is out as to whether REITs would suffer as a result, however some REIT managers we have spoken to suggested they would consider “deREITing” by converting to C corporation status in this environment. In addition, investors holding high yielding common stocks, such as those in our HYD plan, might be better off holding these shares in a taxable account in order to escape the dividend tax. Presently, dividends held in tax-deferred accounts such as IRAs grow tax-deferred but eventually are taxed as ordinary income upon withdrawal.

Although we favor the notion of eliminating the double taxation of dividends, any attempt to do so will be fraught with complexity until the real problem—the existence of both a corporate and individual income tax—is eliminated.

Also in This Issue:

Quarterly Review of Investment Policy
Inflation Linked Treasuries: Another Look
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield