Focus on the recession risk posed by the “Fiscal Cliff” has diverted attention from a the Dividend Cliff written into current law. Prior to 2003 dividends were taxed as ordinary income at a taxpayer’s marginal income tax rate—far above the tax on long term capital gains. In the tech bubble of the 1990s dividends were deemphasized as investors and corporations developed an unhealthy fixation on capital gains. Companies favored share buy-backs over dividend increases, partly to boost near-term EPS, stock price, and the value of management’s stock options. Buybacks conveniently obscured the magnitude of executive compensation via stock options.
Dividend Renaissance
But in 2003, after the economy was rocked by a series of accounting scandals (Enron, WorldCom, Qwest, Lucent, etc.), Washington decided to encourage dividends by cutting the tax on both dividends and long-term capital gains to 15%. With the tax code no longer favoring capital gains and thus share buybacks, dividends increased rapidly—by an average of 10% per year, 2002-2012, excluding the year 2009 when banks slashed their dividends during the financial crisis. With interest rates now hovering near zero, many individuals have turned to dividend paying stocks as a source of income.
This shift toward dividends is healthy from the point of view of both investors and corporate governance because:
- Most large, mature companies can pay a decent dividend without penalizing EPS growth, so dividends enhance total return.
- Dividends are far more transparent than share buy-backs, which may be announced but not done, or done merely to offset dilution from employee stock options. Many companies brag about “returning capital to shareholders” via buy-backs even though the share count does not actually decline.
- Dividends impose more financial discipline on companies because they have to be paid regularly or the stock price will crater.
- Dividends are convenient for investors, and a regular tangible payout is a salutary steadying influence on the behavior of investors. Dividend paying stocks tend to be less volatile.
The Dividend Renaissance is part of a broad improvement in corporate governance over the past decade. Compared to several “go-go” periods in the past (1920s, 1960s, 1980s, 1990s), non-financial companies have behaved in a disciplined, rational manner since 2002. Though overshadowed by the financial crisis, this is a positive trend that should be encouraged.
Dividend Disaster Looms
But these healthy arrangements are about to end. Under current law, on January 1, 2013:
- The “Bush Tax Cuts” end, so dividends will again be taxed as ordinary income, or a top rate of 39.6%.
- The tax rate on long-term capital gains rises from 15% to 20%.
- Obamacare taxes kick in, so “high income” households pay an additional 3.8% on both capital gains and dividends.
- Consequently the top tax rate on dividends will soar from 15% to 43.4% (39.6% + 3.8%), and the top rate on capital gains will be 23.8% (20% + 3.8%). These huge hikes, of 189% and 59%, respectively, take us straight back to the “bad old days” when the tax code created a strong incentive for corporations to favor buy-backs over dividends.
President Obama supports these huge tax increases as a means of redistributing income. Mitt Romney, by contrast, wants to keep the top tax rate at 15% for both dividends and capital gains, with even lower rates for middle class investors.
The Territorial Imperative
There is another big difference between Obama and Romney that will affect dividend growth. Currently the U.S. has the highest corporate tax rate in the world (35%) which is imposed not only on domestic income, but also on foreign income. So if IBM earns $1 billion in Europe and pays a 25% tax there, it will pay additional tax when it “repatriates” the income to the U.S. As a result, companies do not readily repatriate foreign income, and $1-2 trillion in income is stranded overseas. Well over half of the cash of many multinationals is stuck offshore.
The U.S. is one of the few countries to use this approach of taxing the global income of companies; most nations use a “territorial” system of only taxing the domestic income of multinationals. Romney wants to cut the corporate tax rate from 35% to 25%, cut tax loopholes to broaden the tax base, and shift to a “territorial” tax system. If this occurred companies would repatriate huge amounts of cash, much of which would be used for dividends and share buy-backs. President Obama, on the other hand, wants to retain the current “worldwide” tax system and cut the corporate rate to 28%.
A Stark Choice on November 6
If Romney wins the tax on dividends likely will remain fairly low and equal to the capital gains rate, and corporate tax reform will encourage dividend hikes. So the current pattern of fairly rapid dividend increases would continue, even if profit growth is not particularly rapid. For example, if 2013 S&P 5000 EPS is $106 and grows only 5% per year until 2017, and if the dividend payout ratio is a moderate 36% by 2017, dividends will grow 9% annually, 2012-2017. If interest rates remain low, yield hungry investors will likely “pay up” for stocks (as they have already done for high yield stocks such as telecom and utilities), causing the PE of the S&P 500 to expand. On the other hand if Obama wins and the tax on dividends soars we should see a sharp slowdown in dividends, with negative implications for corporate governance and stock prices.
The Stakes Are High
David Bianco, Deutsche Bank’s highly regarded U.S. Equity Strategist, reckons that under the optimal Romney Wins scenario (15% rate on dividends and capital gains and Territorial System of Corporate Tax) the fair value of the S&P 500 is 1600, versus 1400 under an Obama Wins scenario. So an Obama victory would offset some of the beneficial impact on stock prices of the Fed’s QE3. The negative wealth effect, the hit to corporate confidence, and the reduced after-tax dividend income of retirees would all hurt economic growth. With dividends once again far less tax-efficient, companies would shift toward share buy-backs, reducing companies’ financial discipline and transparency. All this is obviously negative for retirees needing investment income.
