Dividends: Proposed New Tax Rates
By Robert McConnaughey
February 27, 2012
One element of President Obama’s budget proposal which is beginning to attract attention is the proposed tax treatment of dividends. In recent budgets, dividend tax rates have run at 20% for the top income earners, but in this year, Obama proposes that those rates go up to marginal levels, where the top rate would be 39.6%. With the so-called Bush tax cuts due to expire on December 31, Congress must pass legislation to extend all or part of them, but this is far from a sure thing. Still, on the face of it, tax rates on dividends for wealthier individuals have a real chance of going up significantly. Does this undermine the attractiveness of dividend paying stocks? While it would not be a positive, we feel it is far from a major negative. Why would a significant tax increase not substantively effect the valuation of dividend paying equities?
This increase is not a given. Given the political might of older voters who are very focused on income, we should not take it as certainty that this additional tax is enacted. Off-shore investors and non-taxable institutions make up a significant percentage (perhaps as much as 50% or more) of the investor base that holds equities. A change here will not impact them. Should taxable investors shed dividend stocks, it is likely that yield hungry, non-taxable investors would take advantage of that opportunity to buy more. The tax on individuals would only impact individuals with incomes greater than $200,000 or joint returns over $250,000. Based on IRS data, 35% of dividends paid to individuals went to taxpayers making less than $200,000 (that is how the IRS cuts the publicly available data). Total dividends received by individuals making more than $200,000 (only 3.2% of tax returns) was about $244 billion (2007 data), but only $101 billion of that was in the form of qualified dividends, the area affected by this potential change. Therefore only 40% of the dividends received by those 60% of the people impacted, or a total of around 24% would be at risk. Having isolated the qualified dividends for this wealthier cohort, it is important to understand how their behaviors might change. Americans with more than $200,000 in income made a total of $2.85 Trillion in income in 2007. Only 3.6% of that haul, or $101 billion, came in the form of qualified dividends. Will behaviors change markedly around a change in taxation on that 3.6% of total income?
Universally, taxpayers are clever and efficient at finding ways to avoid paying taxes. My favorite recent example is the booming business in Greece for camouflaged pool covers to avoid satellites picking up the pool’s eligibility for the “luxury pool tax.” So, if this tax is enacted, taxpayers are likely to react by being more focused on how they hold dividend paying accounts, and in all likelihood, allocating income more aggressively into non-taxable savings vehicles, again reducing the overall market impact. History suggests that changes in tax regime have not had a major impact on the returns investors received from dividend paying stocks. The last major tax increase on dividends came in 1953 and dividend paying stocks performed well in the subsequent years. After assessing all the puts and takes, we conclude that the actual effects of this potential tax action are unlikely to significantly impact how the market values dividend paying equities. In fact, the more we dig on this issue, the more it strikes us as a very ineffective way to increase government tax yields. Wealthier investors are probably best served by rechecking how they hold their equity income vehicles.
We continue to believe that we are in a very attractive period for dividend paying equities. With yields from higher credit quality bonds at historically unusual lows, an investing public hungry for income has to consider an increased allocation to equity income. The backdrop is positive for them to do so with strong corporate balance sheets, healthy cash flows and historically low payout ratios creating a solid foundation for reliable and growing dividend yields. Given the strong outperformance of the highest current yielders in 2011 (such as the most bond-like utilities), we continue to advocate seeking out companies with the ability to grow their dividends sustainably in the future and are finding many of those opportunities in today’s markets.
The views expressed are as of 2/27/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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