Insight Line—February 26, 2007

The historical data supporting the benefits of investing in dividend paying stocks in the S&P 500® Index¹ is as impressive as it is incontrovertible. Controlling for the effects of size and allocation drift and keeping in mind that past performance is no guarantee of future results, a $100 investment placed into dividend paying stocks, say back in 1972 and held through year-end 2006, grew to $3,075 or a 10.3 percent annualized gain per annum. Had the same $100 been placed into non-dividend paying stocks invested at the same time and held to year-end 2006, the investment grew to $229 or an annualized gain per annum of just 2.4 percent.² Simply put, when it comes to investment returns, dividends matter. Therefore, is it any wonder investor conversations in early 2007 are overlaid with worries concerning the sunset provision (unless Congress acts to extend the law) of the current favorable tax treatment of dividend income?³ After all, the reasoning suggests, won’t the expiration of the favorable treatment in 2010 hurt future performance?

In order to gauge these future effects, we must first understand whether the Jobs Growth and Tax Relief Reconciliation Act of 2003, which introduced the reduced tax rate in May of that year, benefited dividend paying stocks to begin with. And that question, we learn from researchers at the Federal Reserve Bank of Chicago (the Fed), is indeed debatable.

“How Did the 2003 Tax Cut Affect Stock Prices,”⁴ a study by Gene Amromin, Paul Harrison and Steven Sharpe, implicitly examines investors’ current concerns from a different point of view. The researchers ask, what if the dividend tax cut of 2003 did not provide any benefit to investors? As such, from this point of view, when and if the favored rate expires the impact may very well be nil.

Now I assure you that proving such a theory was not an easy task. Amromin, Harrison and Sharpe posited all manners of comparisons in an attempt to discern whether the tax rate reduction on dividends might be clearly identified as a permanent boost to equity prices. Their analyses compared the price action of stocks, both domestic and abroad, with the companies’ dividend paying “behavior,” including whether or not the company paid a dividend, as well as the timing of the dividend in relation to the enactment of the tax change. “In sum,” the researchers wrote, “We fail to find much, if any, imprint of the dividend tax cut news on the value of the aggregate stock market.”⁵

Granted, I’m summarizing more than 40 pages of in-depth analysis to just one sentence. But I believe after thoroughly reviewing the data and methodology in the analysis, the single sentence fairly conveys the authors’ rather controversial findings—the controversy being that similarly scholarly papers suggest an equally supported but opposite conclusion. That said, I suggest the real issue at hand lies not in the favorable treatment of dividends but in the permanence of the treatment. You see, as the Fed researchers noted, “The tax cut did appear to have statistically significant, cross-sectional effects on stock valuations, with high-dividend firms receiving a boost at the expense of low-dividend firms, although this effect seems to have been short-lived.”⁶ In other words, it appears that investors simply looked past the initial euphoria to the sunset provisions and concluded, as financial theory suggests, dividends in and of themselves represent many important considerations and signals to investors, but tax rates are not high on the list. Perhaps, owing to the fact, as Amromin, Harrison and Sharpe suggest, a large portion of equity allocations are held in tax-advantaged accounts exempt from the favorable treatment.

None of this is meant to suggest that dividends are irrelevant to the investment decision process (though some well-reasoned analysis suggests otherwise). Instead, as I see it, because investors long ago availed themselves of tax-advantaged investment vehicles to isolate dividend income from ordinary tax treatments, the sunset provisions of the Jobs Growth and Tax Relief Reconciliation Act of 2003 just does not represent a meaningfully significant event to today’s equity investor.

¹ The Standard and Poor’s 500® Index (S&P 500) is a broad-based index, the performance of which is based on the performance of 500 widely-held common stocks chosen for market size, liquidity and industry group representation. The index does not include any expenses, fees or sales charges, which would lower performance. The index is unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

² “Dividends Still in Vogue,” Chart of the Day, Ed Clissold, Tim Hayes, and Svetlana Johnson, Ned Davis Research, Inc., January 12, 2007, ©2007.

³ Note, dividend payments, subject to numerous restrictions, are currently taxed at 15 percent rather than at the prevailing personal income tax rates.

⁴ “How Did the 2003 Tax Cut Affect Stock Prices?” by Gene Amromin, Paul Harrison and Steven Sharpe, Federal Reserve Bank of Chicago, Working Paper 2006-17, October 3, 2006. Available at: http://www.chicagofed.org/publications/workingpapers/wp2 006_17.pdf.

⁵ Ibid, page 3.

⁶ Ibid, page 18.

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.