Does issuing dividends: President Bush's plan to eliminate the individual tax on dividends has spurred real strategy debates within companies--with CFOs often differing with their CEOs. (Dividends).

President Bush's proposed tax break on dividends paid to shareholders obviously puzzled the press. Pundits proclaimed that eliminating double taxation of dividends would make corporations cut down on excessive debt. That was the good news. The bad news, as Sen. John Corzine (D-N.J.) told a press conference, was that the proposal "takes cash off the balance sheets of America's corporations that they need to hire and pay employees and to make capital investments." The press can be excused for the confusion: The devil is in the details.

If the tax break were enacted, interest would still be tax-deductible at the corporate level; dividends still wouldn't be. So when it comes to capital structure decisions, corporations will still look at the debt-equity choice the way they always have -- with a bias toward debt. Chuck Bowman, director of corporate finance for SPX Corp., a Fortune 500 multi-industry corporation based in North Carolina, says, "Part of our philosophy is to maintain as low a cost of capital as is prudent for our company, based on its volatility of cash flow. Having debt in the mix is good for shareholders."

The CFO of a $3 billion-in-sales consumer goods company, the product of a recent merger, is even more blunt. "Whether or not dividends are taxed is irrelevant to the capital structure. In my mind, the dividend decision is a completely different decision from the borrowing decision."

While any Bush tax relief for dividends may not sway corporate thinking about capital structure, it might push corporations to disburse more cash to shareholders. Michael Jensen, professor emeritus at the Harvard Business School and managing director with the Monitor Consulting group, certainly hopes so. "This might make the demands of equity holders like those of debt holders," he says, "If that were to happen, it would change corporate America in dramatic ways." Jensen likens the possible effect to that of the leveraged buyout boom of the 1980s, which forced corporations to become more efficient in order to meet debt service requirements. "If you have a corporation with large amounts of cash sloshing around, it's almost impossible for that corporation to behave. The cash burns a hole in their pocket," Jensen says. A study publicized by the Business Roundtable in January indicated that Jensen might have good cause for his optimism. "There's a consensus that this will give added incentive for corporations to pay out a higher portion of their earnings in dividends," said PricewaterhouseCoopers economist Ken Werz, who helped prepare the study.

But the consensus doesn't include Robert D. Arnott, chairman of First Quadrant, a Pasadena, Calif.-based quantitative investment firm managing approximately $13 billion in assets. "There's an Achilles heel in Bush's proposal -- the deemed dividend," he notes, explaining that companies may choose to a "deemed" dividend policy, in which they issue a phantom dividend, increasing the shareholder's cost basis in lieu of paying an actual dividend. Shareholders ought to be indifferent to receiving cash in a dividend or an increased cost basis in the shares, he reasons, so "it's an open invitation for companies to retain all or more of their earnings."

And that's a shame, because companies have a less than stellar record of investing surplus cash. Consider Microsoft, which has only recently announced that it would begin paying a small dividend to common shareholders. Robert J. Schwartz, an analyst with Thomas Weisel Partners in Boston, has a buy rating on the stock, but says the greatest risk to investors is that the company will pour too much cash into questionable projects.

For instance, he calculates that Microsoft's proposed Xbox game console has soaked up $2 billion in cash, and that the project might not even break even for eight years. "X(box) marks the Black Hole," Schwartz writes in a recent report on the company.

Corporate finance aficionados agree that companies ought to invest only in projects that return an economic profit to shareholders -- that is, a return above the cost of capital. So, logically, companies without hot economic opportunities should give shareholders their money back, either through dividends or heretofore more tax-efficient stock buybacks. "If companies retain a little bit of their earnings, they'll invest in the most important initiative for their long-term competitiveness," Amott says.

"If they retain a little more, they'll invest in the next best, and so on. It's pretty arrogant for companies to think that their fifth-best idea out of a limited range of choices is better than their shareholders' number one best idea in an unlimited range of choices."

But there's a flip side to the argument -- that giving cash back to shareholders is an admission that the company doesn't have any really good ideas left. That may be why investors hammered Microsoft when the company announced its intention to pay even a small dividend.

Doron Nissim, a professor of accounting at Columbia University, has looked closely at dividends and found that, by and large, a dividend is a strong signal of good times ahead that usually triggers a positive market reaction. Companies are reluctant to cut dividends, so the stock market figures an increase must mean that earnings prospects are good.

"But that signaling element is missing from Microsoft," he says, "If you're a manager of a company that doesn't have a lot of cash and you increase dividends, you tell investors you are optimistic about your ability to sustain them in the future. In the case of Microsoft, the information story doesn't hold, and you're left with the alternative story -- that is, if they increase the dividend, it must imply that they don't have any good investments."

By and large, CEOs are reluctant to send that signal, no matter how strong the economic case may be. "Already, in executive meetings, the CFOs are saying loudly that if the president's tax bill goes through unaltered, we'll no longer have a strong argument for holding a large cash hoard on our balance sheet, so we should dividend it out -- while CEOs are saying that would be like sending out a mass mailer that we don't have ideas," says Michael Mankins, managing partner of the San Francisco office of Marakon Associates, an international strategy consulting firm.

Until now, the CEO's argument has been persuasive, especially when coupled with the fact that paying dividends subjected shareholders to tax. if dividend recipients no longer have to pay tax, the balance will tilt a bit more in favor of the CFO -- but not too much more.

After all, the biggest shareholders are pension funds and other institutions that don't pay tax anyway, so a tax break on their dividends won't make any practical difference to them. Individuals who might have to worry about a tax on dividends don't have a lot of corporate governance clout. Making dividends tax-deductible at the corporate level -- so that dividend payments were treated just as favorably as debt service -- might make more sense from an overall shareholder perspective, but that's not what's on the table.

Gregory J. Millman is a freelance business writer in New Jersey and a regulator contributor to Financial Executive. He can be reached at [e-mail].