{"id":201,"date":"2012-10-17T01:52:14","date_gmt":"2012-10-17T01:52:14","guid":{"rendered":"http:\/\/www.wallstreetandkstreet.com\/?p=201"},"modified":"2012-10-19T17:38:12","modified_gmt":"2012-10-19T17:38:12","slug":"dividend-disaster","status":"publish","type":"post","link":"https:\/\/www.wallstreetandkstreet.com\/?p=201","title":{"rendered":"Off the Dividend Cliff?"},"content":{"rendered":"<p>Focus on the recession risk posed by the \u201cFiscal Cliff\u201d has diverted attention from a the Dividend Cliff <strong>written into current law<\/strong>.\u00a0 Prior to 2003 dividends were taxed as ordinary income at a taxpayer\u2019s marginal income tax rate\u2014far above the tax on long term capital gains.\u00a0 In the tech bubble of the 1990s dividends were deemphasized as investors and corporations developed an unhealthy fixation on capital gains.\u00a0 Companies favored share buy-backs over dividend increases, partly to boost near-term EPS, stock price, and the value of management\u2019s stock options. \u00a0\u00a0Buybacks conveniently obscured the magnitude of executive compensation via stock options.<\/p>\n<p><strong>Dividend Renaissance<\/strong><\/p>\n<p>But in 2003, after the economy was rocked by a series of accounting scandals (Enron, WorldCom, \u00a0Qwest, \u00a0Lucent, etc.), Washington decided to encourage dividends by cutting the tax on both\u00a0 dividends and long-term capital gains to 15%. With the tax code no longer favoring capital gains and thus share buybacks, dividends increased rapidly\u2014by an average of 10% per year, 2002-2012, excluding the year 2009 when banks slashed their dividends during the financial crisis.\u00a0 With interest rates now hovering near zero, many individuals have turned to dividend paying stocks as a source of income.<\/p>\n<p>This shift toward dividends is healthy from the point of view of both investors and corporate governance because:<\/p>\n<ul>\n<li>Most large, mature companies can pay a decent dividend without penalizing EPS growth, so dividends enhance total return.<\/li>\n<li>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.\u00a0 Many companies brag about \u201creturning capital to shareholders\u201d via\u00a0 buy-backs even though the share count does not actually decline.<\/li>\n<li>Dividends impose more financial discipline on companies because they have to be paid regularly or the stock price will crater.<\/li>\n<li>Dividends are convenient for investors, and a regular tangible payout is a salutary steadying influence on the behavior of investors.\u00a0 Dividend paying stocks tend\u00a0 to be less volatile.<\/li>\n<\/ul>\n<p>The Dividend Renaissance is part of a broad improvement in corporate governance over the past decade.\u00a0 Compared to several \u201cgo-go\u201d periods in the past (1920s, 1960s, 1980s, 1990s), non-financial companies have behaved in a disciplined, rational manner since 2002.\u00a0 Though overshadowed by the financial crisis, this is a positive trend\u00a0 that should be encouraged.<\/p>\n<p><strong>Dividend Disaster Looms<\/strong><\/p>\n<p>But these healthy arrangements are about to end.\u00a0 <strong>Under current law<\/strong>, on January 1, 2013:<\/p>\n<ul>\n<li>The \u201cBush Tax Cuts\u201d end, so dividends will again be taxed as ordinary income, or a top rate of 39.6%.<\/li>\n<li>The tax rate on long-term capital gains rises from 15% to 20%.<\/li>\n<li>Obamacare taxes kick in, so \u201chigh income\u201d households pay an additional 3.8% on both capital gains and dividends.<\/li>\n<li>Consequently <strong>the top tax rate on dividends will soar from 15% to 43.4%<\/strong> (39.6% + 3.8%), and the top rate on capital gains will be 23.8% (20% + 3.8%).\u00a0 These huge hikes, of 189% and 59%, respectively, take us straight back to the \u201cbad old days\u201d when the tax code created a strong incentive for corporations to favor buy-backs over dividends.<\/li>\n<\/ul>\n<p>President Obama supports these huge tax increases as a means of redistributing income.\u00a0 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.<\/p>\n<p><strong>The Territorial Imperative<\/strong><\/p>\n<p>There is another big difference between Obama and Romney that will affect dividend growth.\u00a0 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.\u00a0 So if IBM earns $1 billion in Europe and pays a 25% tax there, it will pay additional tax when it \u201crepatriates\u201d the income to the U.S.\u00a0 As a result, companies do not readily repatriate foreign income, and $1-2 trillion in income is stranded overseas.\u00a0 Well over half of the cash of many multinationals is stuck offshore.<\/p>\n<p>The U.S. is one of the few countries to use this approach of taxing the global income of companies; most nations use a \u201cterritorial\u201d system of only taxing the domestic income of multinationals.\u00a0 Romney wants to cut the corporate tax rate from 35% to 25%, cut tax loopholes to broaden the tax base, and shift to a \u201cterritorial\u201d tax system.\u00a0 If this occurred companies would repatriate huge amounts of cash, much of which would be used for dividends and share buy-backs.\u00a0 President Obama, on the other hand, wants to retain the current \u201cworldwide\u201d tax system and cut the corporate rate to 28%.<\/p>\n<p><strong>A Stark Choice on November 6<\/strong><\/p>\n<p>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.\u00a0 So the current pattern of fairly rapid dividend increases would continue, even if profit growth is not particularly rapid.\u00a0 For example, if 2013 S&amp;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\u00a0\u201cpay up\u201d for stocks (as they have already done for high yield stocks such as telecom and utilities), causing the PE of the S&amp;P 500 to expand.\u00a0 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.<\/p>\n<p><strong>The Stakes Are High<\/strong><\/p>\n<p>David Bianco, Deutsche Bank\u2019s 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&amp;P 500 is 1600, versus 1400 under an Obama Wins scenario.\u00a0\u00a0 So an Obama victory would offset some of the beneficial impact on stock prices of the Fed&#8217;s QE3.\u00a0 The negative wealth effect, the hit to corporate confidence, and the reduced after-tax dividend income of retirees would all hurt economic growth.\u00a0 With dividends once again far less tax-efficient, companies would shift toward share buy-backs,\u00a0 reducing companies&#8217; financial discipline and transparency.\u00a0 All this is obviously negative for retirees needing investment income.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Focus on the recession risk posed by the \u201cFiscal Cliff\u201d has diverted attention from a the Dividend Cliff written into current law.\u00a0 Prior to 2003 dividends were taxed as ordinary income at a taxpayer\u2019s marginal income tax rate\u2014far above the &hellip; <a href=\"https:\/\/www.wallstreetandkstreet.com\/?p=201\">Continue reading <span class=\"meta-nav\">&rarr;<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[40,22,42,41],"class_list":["post-201","post","type-post","status-publish","format-standard","hentry","category-uncategorized","tag-buy-backs","tag-dividends","tag-election","tag-tax-policy"],"_links":{"self":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/201","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=201"}],"version-history":[{"count":6,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/201\/revisions"}],"predecessor-version":[{"id":207,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=\/wp\/v2\/posts\/201\/revisions\/207"}],"wp:attachment":[{"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=201"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=201"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.wallstreetandkstreet.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=201"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}