The simple, indisputable truth is that a lower dividend tax rate is better for investors than a higher dividend tax rate.  With a lower rate, investors get to keep more of the dividend income they receive.

It is little surprise then to see the market bothered by the thought that the currently low dividend tax rate (top rate of 15%) could soon be going up -- and perhaps by a lot -- either by default should we go over the fiscal cliff on January 1 or by legislative choice in a compromise to avoid the fiscal cliff. 

We will concede the point that a higher dividend tax rate is not a positive.  At the same time, though, it will not be the strong negative some pundits are suggesting. 

Frankly, what should concern investors more than the dividend tax rate going up is the prospect of earnings going down. 

The Path to a Higher Dividend Tax

Unless there is an agreement to avert the fiscal cliff, ordinary income tax rates will go up for everyone and the tax rate on qualified dividends will revert to the ordinary income tax rate, which would be 39.6% for the highest tax bracket.

Individuals making over $200,000 and married couples filing jointly making more than $250,000 will also pay an additional 3.8% tax on dividend income to help pay for the Affordable Care Act, taking the dividend tax rate as high as 43.4% for some payers.

Currently, President Obama is pushing for an extension of the lower income tax rates for everyone except the top 2% of earners.  House Majority Leader Boehner has said the GOP is open to revenue increases, but that it does not want income tax rates to go up for anyone.

The sense we get is that it will not be an easy walk along the path to compromise.  If a compromise is struck, a number of political pundits think it will include a hike in the capital gains and dividend tax rates.  

Many of those same pundits expect the top, long-term capital gains tax rate to be increased from 15% to 20% (23.8% for high-income earners).  There isn't any consensus on where the dividend tax rate will settle, but there is a widely-held belief that it will be noticeably higher than it is today at least for high-income earners.

A 43.4% dividend tax rate for upper-income earners is viewed as the worst scenario.  Anything less, therefore, could be greeted with a sense of relief (relatively speaking).

Either way, the prevailing expectation today is that investors will soon be keeping less of their dividend income than before and that the market will have a tough time dealing with that.

Change Happens 

It is always tough to handle change after something has been in place for so long.  That is true in life as much as it is in the stock market.  

The maximum tax rate on qualified dividends has been frozen at 15% for the past nine years. 

Adjusting to a higher dividend tax rate will not be easy.  Of course, it is easy to forget that dividends have been taxed at the ordinary income rate for most of the last 50 years, with some modest exemptions along the way.  From 1987-2002, there were no exemptions.

In a manner of speaking, investors have been spoiled the last nine years with the low dividend tax rate.  It is only natural that the thought of a tax hike coming soon would be upsetting and viewed as a catalyst to sell before the tax increase is implemented.

There are some pertinent economic and market-related factors, however, supporting the view that the impact of a higher dividend tax will not be as negative as some fear once the reality of a higher dividend tax is established.

• According to the 2010 Survey of Consumer Finances, 49.9% of families (synonymous with households) held stock, either directly or indirectly, in 2010.  Only 15.1% of all families, however, directly held individual stocks. 
• A higher dividend tax will disproportionately target high earners (>$250,000 for married couples and >$200,000 for individuals), who comprise a small portion of the total population.
• According to the 2010 Survey of Consumer Finances, less than half of families (47.8%) in the 90-100 percentile of income held stocks.
• Interest or dividends accounted for just 3.6% of income for all families in 2010 (for families in the top decile, interest or dividends contributed 8.7% of income).
• Most negative assumptions about the impact of a dividend tax hike ignore the fact that dividend-paying stocks are not held exclusively in taxable accounts. Among families that held equity, either directly or indirectly, ownership through a tax-deferred retirement account was the most common. 
• For the better part of the last 50 years, dividend income has been taxed at ordinary income tax rates.  Over this period, the annualized rate of return for the S&P 500 with dividends reinvested was 9.47% (5.18% inflation adjusted). Clearly, despite much higher dividend tax rates than what are currently in place, the S&P 500 has still risen sharply on a price and total return basis over the last 50 years.
• The Tax Policy Center estimates that tax revenue will increase $8 bln with the expiration of the high-income capital gains and dividend tax rates.  By comparison, it is estimated that the expiration of the Social Security payroll tax cut, which impacts every income group, will increase tax revenue by $115 bln.
• Dividend-paying stocks may be worth less with a higher dividend tax, yet many will still hold better relative value than longer-dated Treasuries with low, fixed coupon rates and limited price appreciation potential.  

Correlation, Not Causation

Some skeptics will point to the 2003 dividend tax cut as proof that a dividend tax hike will be terrible for the market.  To make their case, they will argue that dividend payouts increased and that the stock market went up markedly after the dividend tax was cut.

That viewpoint, however, confuses causation with correlation.

On this point, we would draw your attention to the research on the 2003 dividend tax cut that was done by Federal Reserve Board Economist Jesse Edgerton (2010, 2012).  His findings refute the analysis of others who claimed the tax cut caused the large increase in aggregate dividend payouts.

Edgerton's work revolved around four rebuttal points:

1. The post tax-cut increase in dividend payouts coincided with a surge in corporate profits, such that the dividend payout ratio did not rise.

    2.    Share repurchases increased even more rapidly than dividend payouts, even though they did not have preferential tax treatment.

    3.    Dividend payouts by REITs also rose sharply, yet they did not qualify for reduced taxation and

    4.    The stock market was forecasting an increase in dividend initiations by mid-2002 or before the dividend tax cut had even been proposed.

The summation of these four points combined is that aggregate dividend payouts would have increased substantially even without the dividend tax cut.  The reason being is that the U.S. economy and corporate earnings were just starting to gain traction again in early 2003 after the lull of the 2001 recession.

Earnings Matter

That last point is integral to the discussion today.  Unlike early 2003, earnings aren't just starting to gain traction.  They are decelerating and are actually already declining for many companies.

An earnings slowdown is notable because dividends are paid from after-tax income.  To the extent that earnings go down and companies use more of their earnings to pay dividends, the greater the risk there is that dividends get cut or dividend growth is stalled.

Some pundits claim the higher dividend tax will persuade companies to alter their dividend payout policy, perhaps foregoing increased dividend payments for increased share buybacks or other purposes.

That may ring true for some companies, yet Edgerton's work supports the argument that the trend in a company's earnings will have a stronger influence on its dividend payout policy.  In that light, investors looking for dividend growth may want to avoid companies with decelerating/declining earnings and high payout ratios.

A conservative pathway would be to favor "Dividend Aristocrats," which are companies that have increased their dividend for at least 25 years in a row.  That period encompasses a time when the dividend tax rate was much higher than it is today; and there are plenty of "Aristocrats" from which to choose -- 51 in all according to dividend history compiled by Standard & Poor's.

What It All Means

There is much ado about the dividend tax rate going up.  It is not much ado about nothing.  A higher dividend tax will reduce the value of dividend-paying stocks.

Still, there are many pertinent factors -- history being chief among them -- that suggest dividend-paying stocks will stand the test of a higher dividend tax rate.

Although many dividend-paying stocks have been among the market's worst performers of late, we suspect concerns about a higher capital gains tax rate have been the bigger driver of those losses. 

Lest we forget, the search for yield in recent years has raised the appeal of dividend payers, many of which have enjoyed considerable price appreciation, including the dividend-darling utility stocks.

There will be an adjustment period to a higher dividend tax that will weigh on many dividend payers.  However, the point to remember is that the trend in earnings will have more of an impact on dividend policies than will the dividend tax rate.

With the deceleration in earnings, the pace of dividend growth could slow in the near term.  That said, several thoughts should stick with income investors who have a long-term orientation:

• Dividend Aristocrats have increased their dividend through myriad economic and tax environments.  In all likelihood, most if not all of these companies will continue to do so regardless of the prevailing tax rate on dividends.
• Dividend income in tax-deferred accounts goes untaxed until it is withdrawn.
• U.S. corporations will be looking for ways to maintain their shareholder base with the retirement of the baby boomers. Dividend growth will remain an important tying factor for that demographic, which will be seeking yield in a bid to stay ahead of inflation.
• With U.S. companies sitting on piles of cash, rising demands to bolster shareholder value in a low economic growth, low investment return environment are apt to keep company boards focused on paying dividends.
• With or without a higher dividend tax, the total return proposition longer-term still favors dividend-paying stocks over Treasuries.

--Patrick J. O'Hare, Briefing.com

(Note: If you'd like a list of the Dividend Aristocrats, please feel free to email me)