for Dividend-paying Stocks?
May 29, 2012
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The Bush tax cuts are due to expire at the end of this year, but owners of dividend-paying stocks need not be afraid. Historically, changes in tax regimes have had little effect on the value of the aggregate stock market. Historical data show that even vulnerable asset sub-classes – high-yield stocks, for example – have not lost value long-term as a result of similar tax increases.
For investors, allowing these tax cuts – which passed in 2001 and 2003 – to lapse outright would mean a return to taxing dividend income at the same rate as other investment income, such as bonds and REITs. Of course, it’s not at all clear that’s how things will actually play out.
In 2010, when facing the original expiration date, for example, President Obama and Republicans agreed to delay the expiration of the tax cuts until the end of 2012. But things may be different once the pressures of this year’s presidential election have passed. Financial strains on government argue in favor of at least some tax increase, if not a full reversion to Clinton-era levels, and the likelihood of compromise on both sides is growing. The ”easy” path will be to just let the cuts expire, especially since there will be little time between the November election and the end of the year. But it’s not at all clear that the voters will tolerate “easy” this time around.
So some change to dividend taxation is likely, though the worst-case scenario – taxing dividends at close to 45% – remains highly improbable. It’s also likely that capital gains taxation will face similar changes. The tax parity established in the Bush cuts between dividends and capital gains has substantial reason and logic behind it, and is likely to remain.
The real question for dividend investors, then, is “will any of this matter?”
One way to discern the answer is to look back to the passage of the cuts, which actually had little impact when they were instated. It’s possible to see this lack of any clear effect on dividend stocks from the tax cuts passed in 2003 in returns by sector from that timeframe. Specifically, let’s consider three periods from 2003: the period prior to Senate Republicans garnering enough votes to approve the tax cut bill (Jan 3 –May 13); the period after the news that the Republicans had the necessary votes went public (May 14 –Dec 31); and the full calendar year. Remember that Vice President Cheney’s vote broke a 50-50 tie, following weeks of wrangling, and up until the last day it remained unclear whether the bill would contain anything close to the significant cut in dividend taxes that was ultimately enacted.
The chart below shows the cumulative realized returns for 2,842 US stocks in select months during 2002 and 2003. The returns are normalized to 100 at the start of each event window. High-dividend firms are those with 2002 dividends to end-of-year price ratio ("dividend yield") greater than 3%; medium dividend firms have dividend yields between 1% and 3%, and low-dividend firms have dividend yields of less than 1%. Cumulative returns, depicted In the bottom panel, are based on the three-factor Fama-French model, optimized over the second halves of 2002 and 2003.
The chart below depicts cumulative realized returns for the S&P 500 stocks and the Bloomberg REIT Total Return index in select months surrounding the 2003 dividend tax cut. The two event windows are represented by shaded areas. The returns are normalized to 100 at the start of each window.
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