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Dividend Tax Reform

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

The President’s vision for tax reform and fiscal stimulus triggered an immediate hostile reaction from the opposing party. Politics as usual in Washington doesn’t change much no matter which party occupies the White House. It’s all considered just good clean fun in Washington. The Democrats will now present their vision, and the games will begin.

Few economists think the double taxation of dividends is a good thing. There is also a convincing argument that the total level of corporate tax is burdensome. Why else corporate tax flight? Fewer companies will invest in the US when tax rates are higher than competing countries. Corporations have an absolute duty to manage their tax costs just as any other cost, and will migrate (taking their capital, employment and contributions to the local economy with them) to locations where the total economic package is the most favorable.

Moreover, if there is a good reason to allow corporations to deduct interest payments but not dividend payments, I have never heard it. The disparity encourages corporations load up their balance sheets with debt. In the process, it distorts markets and raises the cost of capital. The proposal is silent on this important point.

So, some type of reform may be in order. Personally, I would prefer to see a cut in the corporate tax rate, or making dividend payments tax deductible. However, we have a long way to go and will witness lots of class warfare before anybody’s tax proposal becomes law. Look for a good fight, probably as close as the recent Fiesta Bowl, to be decided at the very last second in double overtime, after at least one very questionable official call.

Just for fun, let’s try to imagine a world with a reduced tax on dividends. How would that change capital markets? How would it affect current price levels and future returns?

Corporations would come under pressure from shareholders to begin to make regular distributions, a good concept that has been sorely neglected recently. After all, presumably that’s why folks invest. Investors will certainly like dividends better if tax rates are lower. A zero tax rate is a compelling reason to prefer dividends to long term capital gains. To the extent that retained earnings are not necessarily always used wisely or appropriately “a very big issue in corporate governance” this is a good thing.

Stocks that pay dividends ought to be much more attractive if part or all of their dividends are not subject to tax. So, all other things being equal, the price of them should go up. This onetime adjustment would reduce the cost of capital for those companies.

Should you be tempted to load up on high dividend stocks today, be aware that the probability of a tax reduction has already been factored into the current price. That’s certainly a big part of the post New Year’s price surge. You can bet Wall Street is watching with great interest and handicapping the outcome on a second by second basis.

Corporate and government bonds will still be fully taxable, and so the value of them to investors would not change much. To some extent they would compete against dividend paying stocks, but the risk level is entirely different, so they are not entirely interchangeable. Many taxable bonds are held in tax exempt organizations anyway. Other institutions, particularly insurance companies must hold a high percentage of their portfolios in bonds by law. So, on balance, I wouldn’t expect much of a change.

Municipal bonds will be affected, but probably not as much as you might think. Their chief competition is taxable bonds. It’s hard to imagine many municipal bond buyers suddenly deciding to become equity investors because the risk level is so much higher. After all the corporation could decide not to pay a dividend in the future, and stocks have much higher volatility. To the extent that municipal bonds are somewhat less competitive, the cost of capital will rise for local and state governments and yields will rise. This will hurt capital values for existing municipal bonds, so don’t get caught with a long duration municipal bond portfolio. Of course, you wouldn’t want to hold a long duration bond portfolio of any type anyway.

Should the dividend tax reduction/elimination survive the legislative brawl, you can be sure Wall Street will rush to provide us all with funds and other investments structured to capture the benefits. Expect to see hybrid offerings like preferred stocks that have preference over common stock for any available corporate cash, but are taxed as dividends rather than interest. Mutual fund companies will hit the street running with high dividend stock funds.

After the dust settles, we will revise our investment recommendations accordingly. Keep tuned for more exciting developments.