The Jobs and Growth Tax Relief Reconciliation Act of 2003
June 16, 2003

The rather verbose title above is the official name for what most investors are terming the “Dividend Tax Cut.”  Last week the President signed into law a $350 billion economic stimulus package that includes a series of tax cuts and increases in depreciation rates and child credits.  However, the provision that garnered the most headlines was a significant reduction in the tax rate applied to the receipt of corporate dividends.  As the chart below illustrates, the top tax rate for dividends (red line) falls this year from nearly 40% to 15%.  Unexpected by most, but surely welcomed by investors, the top tax rate for long-term capital gains (green line) also falls to 15%.  Among the other provisions of the tax package depicted below are a slight reduction in the top income tax rate (blue line) and an increase in the child tax credit (blue bars).  Approximately 25 million households should begin receiving $400 per child rebate checks this summer.

Estate tax reform, courtesy of the also inspiringly named “Economic Growth and Tax Relief Reconciliation Act of 2001,” calls for small annual reductions in the estate tax rate (brown line) culminating with a 2010 drop to 0% (incentive to plan your demise for seven years from now?!?) before returning to 60% in 2011.  What’s going on here?  With the passage of this bill most Americans were introduced to the concept of “sunset provisions.”  As the chart below clearly illustrates, all of these tax reductions are short-term in nature and return to their pre-tax cut levels by 2011, thus the “sunset.”  The key question is whether these sunset provisions actually come to pass or will future legislation lead to a different path.  We’ll leave that debate for the politicians and instead focus our thoughts on the implications and beneficiaries of the new tax law changes.

 
 
Beginning at once, and retroactive to the start of this year, taxable equity investors will clearly benefit from the lower tax rate applied to their dividend income.  Those taxpayers in the highest current tax bracket will immediately experience a 38% increase in after-tax dividend returns without taking on any additional risk!  However, as pie chart below indicates, only slightly more than half of all dividends currently accrue to taxable investors.  As taxable investors will no longer have an inherent bias towards capital gains it is likely that the percentage of overall dividends paid to taxable investors will increase.  Additionally, beginning with asset sales after May 6, 2003, all taxable investors will benefit from a 5-percentage point drop in the long-term capital gains tax rate. 
 
 
 

Getting back to the elaborate title of this tax package, job creation and economic growth are the primary objectives.  Even though the tax plan covers the next eight years, 60% of the cuts are targeted to occur before the end of next year.  While it has created the lion’s share of the headlines, only $23 billion of the $210 billion benefit expected over the next eighteen months comes from dividend and capital gains relief.  The vast majority, $187 billion, is designed to spur consumer and business spending.  Consumers will benefit from lower income tax rates, elimination of the “marriage penalty,” a reduction in the Alternative Minimum Tax, and the aforementioned increase in the child tax credit.  Businesses will benefit from bonus (accelerated) depreciation and an increase in the amount of equipment small businesses can expense in the first year. 

Implications for Westwood Portfolios
 
Through the late 1990’s, investors were searching for the next big price mover, or the next $20-40 in price appreciation.  After living through a bear market and a new, slower economic environment, investors have realized that this situation does not happen anymore.  As investors maintain the belief that they will not get 12% returns every year (the long term average for large company stocks), it becomes more important to consider everything that goes into owning a stock.  The result is investors placing a premium on dividend yields and beginning to favor dividend paying securities as total return investing regains in popularity.  Receiving 3-6% of one’s total return through dividends makes a stock worth owning through market fluctuations.

Westwood portfolios have become beneficiaries of increasing investor preference for dividends returns.  Companies with strong balance sheets and superior free cash flow which have the flexibility to initiate or raise their dividend payouts have been in our portfolios for the past year.   Due to insider ownership at many corporations, we believe that the new tax relief act will cause companies to re-examine their dividend policies by increasing the incentive for corporate executives to return money to shareholders through dividends rather than through share buybacks or investments in low return on equity  projects. 

Below, we have outlined three examples of companies that could be impacted by a change in the dividend tax laws.  Each company has significant insider ownership with attractive equity valuations.  The new tax laws could make each more attractive as an investment. 

ConAgra Foods (CAG - $25.00) – Comparison of the dividend yield of ConAgra to the yield received from owning the company’s bonds:   

 
 
 
Before the Jobs and Growth Tax Relief Reconciliation Act of 2003, dividend income was taxed to individuals at a 35% rate.  A holder of ConAgra foods, receiving a dividend yield of 4%, would net 2.60% on an after tax basis.  If that same investor held the ConAgra bonds due in 2011, he would net a slightly higher after tax yield of 2.62%.  That investor would receive an additional 19 basis points in after tax yield through owning a perceived safer investment. 

After the tax law changes, the dynamics between the after tax yields on the equity and fixed income investments changes dramatically.  With the new 15% tax rate on dividend income, ConAgra investors now receive 3.40% on an after tax basis.  The yield received through dividends now becomes 78 basis points above that received by fixed income investors. 

With a 3-year run in fixed income investments, a dividend growing 8% per year and 2x free cash flow coverage, an investment in an undervalued equity becomes much more attractive.  

Starwood Hotels (HOT - $29.00) Comparison of dividends paid through parent of subsidiary:
 
 
 

Starwood Hotels currently pays its dividend through a REIT (real estate investment trust) subsidiary.  Assuming 5% revenue growth (under a travel recovery scenario) and continued payout of 90% of earnings under current mandates, we can assume that dividends growth at the same rate as free cash flow (FCF).  Because dividends paid out in this manner are not taxed at the corporate level, investors could still expect to pay a 35% tax rate.  Under this scenario, investors are netting 2% on an after tax basis from dividend income. 

Due to the significant insider ownership at Starwood, the company could consider changing their policies and pay the dividend through the parent C Corp where investors would realize lower taxes on dividend income, increased benefit of the company’s leverage to the hotel cycle and the share in the profits realized through asset sales gains. 

Clear Channel Communications (CCU - $40.70) Additional returns can be gained through initiation of a dividend payment. 

Clear Channel is an example of a company that currently does not pay a dividend but has made significant strides in strengthening their balance sheet.  Concurrent with a planned slowdown in acquisitions, the company has become focused on internal growth and free cash flow generation. 

The company is gaining market share and expanding margins.  They are a candidate to initiate a new dividend due to their declining levels of leverage, rising free cash flow and again, significant levels on insider ownership.  Below is a chart outlining the additional after tax yield that could be gained from a new dividend payment by CCU.  We believe that with their strong free cash flow, they could support a dividend level of $1.50-2.00 within three years.  At the new 15% tax rate, investors could realize an additional 2% per year from dividend yield alone. 

 
 

While the provisions of this tax bill will not, in and of themselves, cause the markets to rise, they are an incremental positive to investors and consumers.  The robust post-war rally has been bolstered by, among other things, a strong increase in consumer confidence, continued gains in corporate productivity and earnings and a slowing in the pace of layoff announcements.  No doubt considerable risks remain, but the tax bill should have its desired impact and help speed economic recovery.

This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.