What Does a Dividend Tax Hike Mean for Dividend-paying Stocks?

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1 What Does a Dividend Tax Hike Mean for Dividend-paying Stocks? May 29, 2012 by Steve Chun Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. 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 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 Page 1, 2018 Advisor Perspectives, Inc. All rights reserved.

2 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 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 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 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. Page 2, 2018 Advisor Perspectives, Inc. All rights reserved.

3 Complicating the analysis is the fact that investments in dividend stocks began to increase around So it is not surprising that some observers would credit the tax cuts with catalyzing the reemergence of dividend investing. But the renewed popularity of dividend-paying stocks was more likely a result of dual market traumas first the bursting of the NASDAQ bubble, then the corporate finance scandals epitomized by Enron. The transparency of dividend payments was welcomed in an environment where growth projections and profit statements could no longer be trusted. At the same time, the ongoing decline in bond yields, which allowed dividends to surpass corporate bonds from the same company, caused many investors to re-think their notions about investing in dividend stocks. By late in the 2000s, broad market dividends were higher than 10-year Treasury bonds for the first time in over 50 years. These capital-market factors, combined with an aging American populace and a collective shift in focus toward retirement income, led investors to rediscover the virtues of dividend investing. Nevertheless, with the exception of in 2011, it has been impossible since to discern any clear Page 3, 2018 Advisor Perspectives, Inc. All rights reserved.

4 return bias in favor of dividend stocks since the passage of the tax cuts. Looking back at earlier changes in the tax code There is no historical evidence that lower taxes on dividend income (relative to capital gains) had a meaningful impact on the performance of high-yield stocks. Lower taxes are a real benefit to all investors, but they did not affect the stock prices of companies paying dividends. Quality companies with consistent, growing, free cash flows and the willingness to share those cash flows with shareholders in the form of dividends are attractive regardless of the dividend tax rate. The chart below from Ned Davis Research looks at previous periods when dividend tax rates (top marginal ordinary income rates) were not the same as capital gains tax rates. One can see no impact of beneficial capital gains rates over dividend tax rates on the performance of dividend-paying stocks. Page 4, 2018 Advisor Perspectives, Inc. All rights reserved.

5 Finally, we looked at three distinct periods since 1979 and compared the difference between the average effective income and capital gains rates: There was an average difference of 6.2% between 1979 and 1986; an average of 0.4% between 1987 and 2002; and an average of 5.9% between 2003 and As the chart below demonstrates, here again, there was no correlation between lower dividend taxes and the performance of dividend-paying stocks. Page 5, 2018 Advisor Perspectives, Inc. All rights reserved.

6 But demand for income-producing equities will continue to grow especially if we are in a protracted Page 6, 2018 Advisor Perspectives, Inc. All rights reserved.

7 low-yield environment. In 2011, the first of the Baby Boomer generation reached what used to be known as retirement age (65). And for the next 18 years, Boomers will be turning 65 at a rate of more than 8,000 a day. Dividends will be an important part of the portfolio for a growing swath of investors. High-quality companies that share their prosperity with shareholders, and that are able to increase their dividends by rising free cash flow, should be a part of any investor s portfolio regardless of the tax rate on dividends. The underlying business models of such companies are the true driving factor behind their performance. Compounded investment income not style, sector, or market capitalization is the true driver of total returns. Ultimately, if dividend taxation changes, the cash flows from dividends are no more disadvantaged than Page 7, 2018 Advisor Perspectives, Inc. All rights reserved.

8 those from bonds and dividends offer more opportunity for growth. Dividends will remain a sound investment no matter how Congress finally decides to act. Steve Chun is director of marketing for Miller/Howard Investments, a boutique manager focused on income-producing equities including dividend stocks, utilities, and MLPs. Page 8, 2018 Advisor Perspectives, Inc. All rights reserved.