The Dividends Are Bad School

In the United States, dividends have historically been taxed at much higher rates than capital gains. Based upon this tax disadvantage, the second school of thought on dividends argued that dividend payments reduce the returns to stockholders after personal taxes. Stockholders, they posited, would respond by reducing the stock prices of the firms making these payments, relative to firms that do not pay dividends. Consequently, firms would be better off either retaining the money they would have paid out as dividends or repurchasing stock. In 2003, the basis for this argument was largely eliminated when the tax rate on dividends was reduced to match the tax rate on capital gains. In this section, we will consider both the history of tax-disadvantaged dividends and the potential effects of the tax law changes.6

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