Portfolio Allocation and Dividend Taxation

Hal Varian does a nice job analyzing the proposal to make dividends tax-free for individuals, from the perspectives of macroeconomics, microeconomics, and--most important--portfolio theory.

What about municipal bonds? Odds are we would see their prices fall, since dividend-paying stocks would be pretty close substitutes under the Bush proposal...

One way to estimate the likelihood of the Bush plan's passing is to watch the prices of municipal bonds over the next few months: the more likely the plan is to pass, the lower those prices are likely to go.

What I was most struck by was Varian's final comments.

If paying dividends became the norm, companies would have to subject more investment plans to market scrutiny, which, by and large, would be a good thing.

But...the Bush plan allows a company to declare a dividend, but not pay it out to shareholders, instead keeping the money as retained earnings. This provision weakens a substantial benefit of changing the tax treatment of dividends.

Discussion Question. One goal of eliminating double taxation of dividends is to encourage more dividend payments. How does this conflict with the goal of the retained-earnings provision, which is to try to minimize changes in the relative tax status of dividends and capital gains?