As an investment, I happen to like China Mobile (CHL). It is the largest mobile phone company in the world by a very large margin, with over a half a billion subscribers. It is a play on the development of the Western parts of China, the poorer and more rural areas, where it has a much higher relative market share than its competitors.
As the Chinese consumer is able to spend more of what he earns, a good portion of that spending is likely to go to more value-added mobile communication services than just voice. Certainly that has been the pattern in the rest of the world.
All of its revenues and earnings come from China, and so as the Yuan increases in value, that will provide an extra kicker to growth. It is also attractively valued, selling for 12.7x this year’s and 12.3x next year's earnings, and has an attractive 3.2% dividend yield. It might not be the absolute highest-return way of investing in China, but it is a pretty conservative, safe way to benefit from the fastest-growing major economy in the world.
However, if I buy 100 shares of the stock at its current price of $51.65, and sell it a year from now at $65, I will earn 25.8% return or $1,335 in capital gains, plus I will collect an additional $168 in dividends. Both of those will be taxed at 15%. The income I get from my paycheck, on the other hand, will be taxed at an average rate much higher than that, and the marginal rate -- or the rate on the additional dollar I earn -- will be taxed at 35%.
This does not seem to make a lot of sense to me. How much I am adding to American society by writing on the markets and the economy is probably a matter of opinion, but the one opinion that matters the most -- that of my employer -- says that it is worth a comfortable, but not typical “Wall Street”-high amount. (I’m sure there will be some snarky commentators who will say that even minimum wage would be evidence of wild overpayment.) However, it seems pretty clear that what I earn from my paycheck, and what most people earn from theirs, is adding more to American society than what I earn from my investment in China Mobile.
Investment is "Better"
The argument in favor of a differential between ordinary income and capital gains is that by investing in stocks, we raise the money for new companies that will grow and provide jobs and help out society at large. That is certainly the case when one is talking about venture capital investments, or even in some small-cap companies. Those sorts of investments can reap very large rewards, not just for the investor, but for the society as a whole. However, is it really true of a company that already has a market capitalization of over $200 billion, like China Mobile has?
The argument for lower taxes on dividends is it avoids part of the “double taxation” problem since the earnings are taxed first as corporate earnings, and then again when they get distributed to investors. However, the nominal corporate tax rate is usually far different from the actual cash taxes a company pays. Just a cursory look at most balance sheets will see large deferred tax items on almost every one of them, and most of those deferred taxes never end up getting paid.
Also, since companies can buy back stock and shrink the shares outstanding, it could effectively pay dividends without paying dividends. The economic consequences of share repurchases and dividend payments are almost identical (imagine the case of a firm with a Dividend Reinvestment Plan, or DRIP, that had 100% utilization).
My investment in China Mobile adds exactly nothing to the productive capacity of America, and since we are talking about existing shares, it does not even do that much to increase the productive capacity of China, unless it helps bid the price of the shares up high enough that China Mobile can raise additional capital at attractive rates though a secondary offering (the exact opposite of what happens with share repurchases, by the way).
But since the operations, investment revenues and earnings all come from China, it does not add anything to America. That being the case, why should the income I get from betting on the direction of CHL shares be considered “better” by the IRS?
The "Fortunate 400"
While many Americans get “some” income from capital gains and dividends, much of it for ordinary people is already tax free, since the stocks are held inside retirement accounts. The vast majority of capital gains and dividend income received by individuals goes to a very small slice of the overall population -- the most wealthy among us.
The pretax share of income going to the top 1% in 2007 (the last year the data is available) was the highest it has been since 1929 (not just a coincidence, in my estimation). The 400 richest Americans had an effective tax rate of just 17% that year, far less than almost anyone in the middle class. The reason is that they don’t get a very high proportion of their income from their paychecks, but rather they get it from -- you guessed it -- dividends and capital gains.
Including the employer portion, someone earning the minimum wage gets taxed almost 17% from the payroll tax alone, which is paid on the first dollar of income, but not on any income above $100,000. For the fortunate 400, that means they are done paying that tax by the time their New Year's Eve hangover clears up.
If the Bush tax cuts expire, the rate on capital gains will go up to 20%, and dividends will again be treated as ordinary income. The capital gains will still be tax-favored, just not quite as favored as they are now.
As for dividends, someone with a $1,000,000 portfolio (all in stocks, and outside of any 401-K or IRA accounts they might have) which was invested in the S&P 500 would earn about $20,000 a year in dividends, and at current rates would pay $3,000 in taxes on that income. If that person were in the very top income bracket (earning over $350,000 a year after all deductions) and the taxes were to expire, their taxes would go up to $7,920. For a typical retiree, the ordinary income bracket would be more like 25%, so the tax would go up by $1,000 to $4,000.
Government needs to be paid for -- huge standing armies don’t come cheap. Someone needs to pay the taxes, but does it make sense for the burden to fall almost entirely on the poor and the middle class?
If we want to still encourage widespread ownership of stocks, a better way would be to say that the first $5,000 of dividends or capital gains are tax free, and everything above that is taxed as ordinary income. For the vast majority of investors, that would be a much better deal and we would also have more tax revenues to bring down the deficit.
CHINA MOBLE-ADR (CHL): Free Stock Analysis Report
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All of its revenues and earnings come from China, and so as the Yuan increases in value, that will provide an extra kicker to growth. It is also attractively valued, selling for 12.7x this year’s and 12.3x next year's earnings, and has an attractive 3.2% dividend yield. It might not be the absolute highest-return way of investing in China, but it is a pretty conservative, safe way to benefit from the fastest-growing major economy in the world.
However, if I buy 100 shares of the stock at its current price of $51.65, and sell it a year from now at $65, I will earn 25.8% return or $1,335 in capital gains, plus I will collect an additional $168 in dividends. Both of those will be taxed at 15%. The income I get from my paycheck, on the other hand, will be taxed at an average rate much higher than that, and the marginal rate -- or the rate on the additional dollar I earn -- will be taxed at 35%.
This does not seem to make a lot of sense to me. How much I am adding to American society by writing on the markets and the economy is probably a matter of opinion, but the one opinion that matters the most -- that of my employer -- says that it is worth a comfortable, but not typical “Wall Street”-high amount. (I’m sure there will be some snarky commentators who will say that even minimum wage would be evidence of wild overpayment.) However, it seems pretty clear that what I earn from my paycheck, and what most people earn from theirs, is adding more to American society than what I earn from my investment in China Mobile.
Investment is "Better"
The argument in favor of a differential between ordinary income and capital gains is that by investing in stocks, we raise the money for new companies that will grow and provide jobs and help out society at large. That is certainly the case when one is talking about venture capital investments, or even in some small-cap companies. Those sorts of investments can reap very large rewards, not just for the investor, but for the society as a whole. However, is it really true of a company that already has a market capitalization of over $200 billion, like China Mobile has?
The argument for lower taxes on dividends is it avoids part of the “double taxation” problem since the earnings are taxed first as corporate earnings, and then again when they get distributed to investors. However, the nominal corporate tax rate is usually far different from the actual cash taxes a company pays. Just a cursory look at most balance sheets will see large deferred tax items on almost every one of them, and most of those deferred taxes never end up getting paid.
Also, since companies can buy back stock and shrink the shares outstanding, it could effectively pay dividends without paying dividends. The economic consequences of share repurchases and dividend payments are almost identical (imagine the case of a firm with a Dividend Reinvestment Plan, or DRIP, that had 100% utilization).
My investment in China Mobile adds exactly nothing to the productive capacity of America, and since we are talking about existing shares, it does not even do that much to increase the productive capacity of China, unless it helps bid the price of the shares up high enough that China Mobile can raise additional capital at attractive rates though a secondary offering (the exact opposite of what happens with share repurchases, by the way).
But since the operations, investment revenues and earnings all come from China, it does not add anything to America. That being the case, why should the income I get from betting on the direction of CHL shares be considered “better” by the IRS?
The "Fortunate 400"
While many Americans get “some” income from capital gains and dividends, much of it for ordinary people is already tax free, since the stocks are held inside retirement accounts. The vast majority of capital gains and dividend income received by individuals goes to a very small slice of the overall population -- the most wealthy among us.
The pretax share of income going to the top 1% in 2007 (the last year the data is available) was the highest it has been since 1929 (not just a coincidence, in my estimation). The 400 richest Americans had an effective tax rate of just 17% that year, far less than almost anyone in the middle class. The reason is that they don’t get a very high proportion of their income from their paychecks, but rather they get it from -- you guessed it -- dividends and capital gains.
Including the employer portion, someone earning the minimum wage gets taxed almost 17% from the payroll tax alone, which is paid on the first dollar of income, but not on any income above $100,000. For the fortunate 400, that means they are done paying that tax by the time their New Year's Eve hangover clears up.
If the Bush tax cuts expire, the rate on capital gains will go up to 20%, and dividends will again be treated as ordinary income. The capital gains will still be tax-favored, just not quite as favored as they are now.
As for dividends, someone with a $1,000,000 portfolio (all in stocks, and outside of any 401-K or IRA accounts they might have) which was invested in the S&P 500 would earn about $20,000 a year in dividends, and at current rates would pay $3,000 in taxes on that income. If that person were in the very top income bracket (earning over $350,000 a year after all deductions) and the taxes were to expire, their taxes would go up to $7,920. For a typical retiree, the ordinary income bracket would be more like 25%, so the tax would go up by $1,000 to $4,000.
Government needs to be paid for -- huge standing armies don’t come cheap. Someone needs to pay the taxes, but does it make sense for the burden to fall almost entirely on the poor and the middle class?
If we want to still encourage widespread ownership of stocks, a better way would be to say that the first $5,000 of dividends or capital gains are tax free, and everything above that is taxed as ordinary income. For the vast majority of investors, that would be a much better deal and we would also have more tax revenues to bring down the deficit.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
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