Dividend-paying stocks should be a sweet spot for income-seeking investors in 2013—whether taxes rise or not. And even if the grinches in Washington can’t strike a deal on the fiscal cliff this week, dividend payers remain an attractive way for investors to stay ahead of inflation.
The stock market finished last week on a down note as the fiscal-cliff negotiations, which seemed to be going well earlier in the week, hit an impasse. The fiscal cliff, a term coined by Federal Reserve Chairman Ben Bernanke to describe the combination of expiring tax breaks and automatic spending cuts set to take effect in 2013, is just days away—and investors are clearly concerned.
While it will impact people in a variety of ways, one area of particular interest to investors is the dividend tax. In 2003, dividends saw a tax cut with the Jobs and Growth Tax Relief Reconciliation Act. Initially set to expire at the end of 2008, it was extended through the end of 2010 and then again through the end of 2012, making it a key component of the fiscal cliff.
This dividend tax cut was substantial, lowering the tax on dividends from the marginal individual income tax rate—with a top rate of 38.6%—to 15% (5% for those in the lowest tax brackets, which was cut in 2008 to 0%.) Many academics have argued that this law was largely responsible for the resurgence in favorable corporate-dividend policy. A study by Eugene Fama and Kenneth French in 2001 on dividend policy observed that the portion of publicly traded firms paying dividends declined steadily from 1980 to 2000, a trend they called “disappearing dividends.” However, Raj Chetty
and Emmanuel Saez
in 2005 found a reversal of that trend after the dividend-tax cut was enacted.
Not surprisingly, investors are worried about the fate of favorable dividend tax policies as we hurtle toward the fiscal cliff. The good news is that this is one area where we have strong visibility. We know that President Obama’s proposal, which is arguably the “worst-case scenario,” would only raise the tax on dividends to 20% from 15%. Even including the additional 3.8% tax on dividends imposed by the health-care reform law, which was upheld by the Supreme Court earlier this year, dividend taxation would remain at a relatively low level. But while there’s a chance that a deal can be cobbled together in the next week, we can’t ignore the very real possibility that no deal is struck by Dec. 31. In this scenario, dividend taxes could temporarily revert back to individual marginal tax rates.
Still, it's unlikely to be a catastrophic event. Here are a few key points and statistics to consider:
Corporate dividend policy has not changed despite the impending fiscal cliff and its impact on dividend taxation:
Investors have historically not altered their preference for dividend-paying stocks in high dividend tax environments. Consider that dividend-paying stocks have outperformed non-dividend paying stocks in a variety of different tax regimes, including periods when the tax on dividends was much higher:
- The aggregate payout ratio on the S&P 500 rose to 29.1% in the third quarter of 2012, from 27.7% in the third quarter of 2011.
- Dividend payments are at a 10-year high, with $277.4 billion having been paid out in dividends this year.
- In the third quarter of 2012, S&P Dow Jones Indices experienced net dividend increases of $8.8 billion, which is believed to be a new record for quarterly dividend payments (in aggregate dollars) for US domestic listed common-stock issues. S&P Dow Jones Indices reported 439 dividend increases during the third quarter of this year, a 25.4% gain over the 350 increases reported during the third quarter of 2011.
- In the third quarter of 2012, 3% of non-dividend-paying companies in the S&P 500 “initiated” dividends, which is almost triple the 10-year average of 1.2%.
- From 1972 to 1978, when the highest tax on dividends was 70%, dividend-paying stocks outperformed non-dividend paying stocks.
- From 1993 to 1996, and then again from 1997 to 2002, when dividends were taxed at the individual marginal tax rate (the highest rate being 38.6%), dividend-paying stocks outperformed non-dividend paying stocks.
- The number of Americans age 65 and older continues to grow. Retirees need significant income, and with the yields on money markets and core fixed income down, dividend-paying stocks will remain relatively attractive. Consider that since 1995 the S&P 500 Index had an average dividend yield of 43% of the yield on the 10-year US Treasury note; the current rate is 116%. And 238 companies in the S&P 500 have a current yield higher than the 10-year Treasury yield.
- In addition, retirees need to be focused on generating positive real income, which dividends offer, and so investors will likely be undeterred in their preference for dividend-paying stocks. Dividend growth has historically outpaced inflation by one percentage point, making it a very attractive solution for those seeking positive real returns.
- A good portion of dividend-paying stocks are held in tax-deferred accounts, such as 401(k) plans, or are owned by institutional investors, which should mean that they will continue to draw interest from investors even if taxes rise.
So as we look ahead to the final week of 2012, there is still a chance that a deal could be struck, one that would include the 20% tax on dividends. However, whether that happens or not, dividend-paying stocks continue to play a crucial role in virtually every investor’s portfolio, particularly given the enduring era of financial repression.
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