Tax Policy and the Bond Market
by Charles B. Carlson, CFA
Dow Theory Forecasts

A lot is being written about President Bush's new tax plan, the centerpiece of which is the elimination of taxes on corporate dividends.

Now, before you get too excited about tax-free dividends, keep in mind that it is still a long shot, in my mind, that a complete elimination of dividends will occur. A more likely scenario is that Bush will compromise on this issue (presumably to gain passage of other parts of its plan), with the tax rate on dividends being cut in half, not totally eliminated.

Still, the odds favor some reduction in the tax rate on dividends, and that's good news for stocks.

But is it good news for bonds?

One of the unintended consequences of a reduction in tax rates on dividends could be a pretty good jolt to the bond market. After all, if all of this money is going to rush into dividend-paying stocks, it has to come from somewhere. Will all of it come from non-dividend paying stocks? Perhaps some will, but I don't suspect a true growth investor will sell his or her Microsoft to buy a utility stock simply because the taxes on dividends are reduced.

No, a more likely scenario is that money will come from the bond market, which means investors will sell bonds and buy dividend-paying stocks.

Lots of money has been flowing into bond funds over the last year, so what happens to the bond market has direct implications on millions of investors.

Bottom line: What's good for stocks is not always good for bonds, and this will likely be proven out should taxes on dividends be reduced or eliminated.

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