The Dividend Tax Cut and Interest Rates free essay sample

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 e added to an investors 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 remises 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 real estate and collectibles, both bonds and stocks are liquid assets, meaning it is easy and inexpensive to find a buyer anytime one wishes to sell. There are millions of brokers and organizations that will gladly buy your bond at market rates; finding a buyer for your rare beanie baby collection would be much more difficult. Since bonds and stocks are substitutes, and the dividend tax cut will make owning stocks more desirable and bonds would become less desirable to investors. Bonds would be purchased in smaller quantities. Economic theory, as well as common sense, dictates that when demand for a good falls, the price of that good will fall as well. So the dividend tax, while having the intended effect of a rise in the price of stocks, will see a corresponding fall in the price of bonds. Ads Aka Battista Ha HOPSCOTCH broker. Rue rentable cobble19 8 Mope 30TH aqua COCOA Activate days enjoyment noggin Eligibly, Kenneth, CAPTIVITY www. Rusk. Rue Composite Koran Noah. Rapacity Ha monopoly_VIII 2 raga! XX Beach, gal._VOW, Waynesboro-m. Rue object-1 Kaplan a XX Beach AT 21 MM. Tanoak, annotate. Oceanographers! The Dividend Tax Cut and Interest Rates [Part 3: The Dividend Tax Cut How Does This Effect Interest Rates? ] More of this Feature Part 1: The Dividend Tax Cut Bushs Plan Part 2: The Dividend Tax Cut Substitution of Bonds for Stocks Part 3: The Dividend Tax Cut How Does This Effect Interest Rates? Part 4: The Dividend Tax Cut How Does Interest Rate Increases from Bonds Effect You? Part 5: The Dividend Tax Cut The Supply Side Part 6: The Dividend Tax Cut Have Your Say Related Resources Bush Offers Dividend Tax Cut Plan Dividend Tax Cut and Economic Stimulus Plan White House Release Dividend Tax Cut and Economic Stimulus Package Tax Policy Center Information on Dividend Tax Cut What does any of this have to do with interest rates? Well, the interest rate on a bond is inversely related to the price of the bond, meaning that as one goes up, the other goes down. Consider a discount bond with a maturity length of one-year. Suppose you buy a $100 bond with a maturity length of 1 year for $90. This meaner that you pay $90 today, and on this date one year from now, you receive $100. The interest rate you get on this bond (formally called the yield-to-maturity) is calculated by: r = (value price) / value In this equation r is the interest rate (or yield to maturity), price is the price you pay for the bond, and value is the amount you get in one year. Now as the price decreases, the interest rate increases. This increase in the interest rate as the price creases is shown in the following chart for a discount bond with a maturity length of one year. This rise in interest rates will not be limited to Just bonds. Banks and other financial institutions use their customers deposits to either buy bonds or to loan to other customers in the form of mortgages, car loans, and business loans. These loans usually carry an interest rate of Prime + X%, where X is a number based on the likelihood the borrower will go bankrupt and default on the loan. The more likely the lender is to default on the loan, the higher X is: this is why Bill Gates gets a utter rate on his mortgage than you do. Since interest rates tend to be calculated based on Prime and the likelihood of the borrower to go bankrupt, there is a perfect relation between them and the prime rate. The prime rate is the interest rate at which banks lend money for a short- specified term to large corporations that have little chance of going bankrupt in the near future. These loans are, in reality, bonds, since the large corporations have to pay them back at a specified date, and the banks can sell these loans to other banks or institutions if they wish. Thus, if the demand for bonds decreases and causes a rise in the interest rate on bonds, the prime rate will increase (because it is as an interest rate on a bond), and cause the rate of interest to rise on all loans. So far we have Just examined changes in demand, but we know that two factors always affect price: demand and supply. What effect will the elimination of dividend taxation have on the supply of stocks and bonds? We know that consumers are now willing to pay more for stocks, and less for bonds. Corporations obtain funds for new projects by either selling bonds or by issuing new stock. Since selling stocks is now more lucrative than issuing bonds, because of the relative change in prices, we should see more companies selling stocks, and fewer companies issuing bonds. Since the supply of bonds by corporations is decreasing, we should see the price of these bonds increase. So this will mitigate the fall in bond prices caused by changes in demand. In theory, it is possible for the supply effect to outweigh the demand effect; this would happen if there were large enough reductions in the amount of bonds issued. This would cause an overall rise in bond prices, and a lowering in interest tats. This is exactly the opposite of what Ive been arguing so far. However, a dramatic fall in the amount of bonds issued is highly unlikely for two reasons. The first is that companies usually prefer to sell bonds instead of issuing new stocks. This is due to the fact that when a company sells stock, it is diluting the ownership of the company. If a company issues too much stock, there is the risk that the a single investor or group of investors will be able to buy enough stock in the company to take it over, which is called a hostile takeover. Because of this, a big rush of new stock issues is unlikely. The second reason this is unlikely is that corporations are not the only entities that sell bonds. The federal government, along with state and municipal governments and public utilities all issue bonds for their funding needs. Most governments are currently running into budgetary crunches and many are running deficits for the first time in years. The federal government will be forced to run a deficit due to increases in spending and declining revenues due to this tax cut. To finance these deficits, governments will be forced to issue more bonds. Because the number of government issued bonds will increase, we should not expect to see a dramatic drop in the total overall value of bonds issued. Most economists feel that the elimination of the dividend tax will have the intended effect of raising the demand and price of stocks, which will cause a rise in the value of the various stock market indices. However, for any change in policy, we must not just examine the intended impact of the policy, but we must determine what its unintended consequences will be. One of the unintended consequences will be that the dividend tax cut will cause a rise in interest rates. This is bad news if youre planning to buy a car or house in the future, as your monthly payments will rise due to higher interest rates. Unfortunately, I havent seen any scientific studies on how much interest rates will rise due to this policy change. Economic theory can only tell us that interest rates will rise; an extensive econometric study is needed to determine what the magnitude of the rise will be. If you have any thoughts or predictions on what will happen, or know of a study I may have missed, please Join us in the forums. I look forward to hearing your input.