A great deal has been written about the "fiscal cliff" that US taxpayers, investors and companies are faced with at the end of this year. Put simply, all of the tax changes made in 2002 and 2003 expire at that time, and the tax code will, in large part, revert to what it was prior to those changes. I will leave it to others to debate the macro economic implications of going over the cliff but I want to focus on one "segment" of the code that has implications to valuation.
In 2003, the tax code was altered to bring the tax rate on dividend income down to 15%, to match the tax rate on capital gains. That was, in a sense, a revolutionary move, at least for the US, since dividends had been taxed much more heavily than capital gains for much of the previous century. I did write a paper in 2003 about the potential implications of the tax law change for businesses that you can read. In effect, I argued that the tax change would have a positive effect on stock prices, that the effect would be greater for "high" dividend paying stocks than for non-dividend paying stocks and that corporate dividend policy would be altered by the change. Now that there is the possibility that the law will be reversed, it is time to revisit the issue.
Dividends, Expected Returns and Stock Prices: Why taxes matter...
Now, introduce a uniform tax rate of 15% on interest income, dividend income and capital gains into this world. Since you need to earn 6% after taxes, you would need to earn 7.06% before taxes:
Let's now change to law to reflect what the tax rate will be on January 1, 2013, if we do revert back to pre-2003 levels. The tax rate on dividends, for individual investors, will revert back to the ordinary income tax rate. At the margin, for unmarried (married - joint filing) investors generating more than $ 85,650 ($142,700) and in income, that rate will be close to 35% (counting just Federal taxes and incorporating the additional taxes that the new health care law will impose on dividends and other investment income) and approach 40% for those with income levels exceeding $178,650 ($217,450). The tax rate on long term capital gains will also go up, but only to the 20% rate that prevailed prior to 2003. If companies continue with a dividend yield of 2% and the price appreciation stays at the 5.06%, investors will earn a much lower after-tax return:
Making it real: The dividend cliff and the S&P 500
Differential impact: High dividend versus non-dividend paying stocks
The Weak Links
1. There is no chance that the fiscal cliff will become reality: This is not the first time that we have faced the possibility of the tax laws reverting back to pre-2003 levels. At the end of 2011, faced with the possibility, Congress and the administration pushed off the day of reckoning at the last moment. It is possible that faced with the catastrophic consequences of going over the cliff, Congress will find a way to avoid it again, but is it guaranteed? Having seen the political dysfunction at both ends of Pennsylvania Avenue over the last decade, I am not as confident as others may be that common sense will prevail and that the cliff will be avoided.
2. Not all investors pay taxes on investment income: In my analysis, I used the tax rates on wealthy individual investors to make my assessment, but tax rates vary widely across investors. There are two critiques that can be mounted. The first is that about 60-70% of stocks are held by non-individuals: mutual funds, pension funds and corporations and the tax rates that these investors may not be affected (or at least not as much) by the change in the tax law. The second is that companies that pay high dividends attract investors who like those high dividends and it is possible that these investors make less income and face less of a hit from the change in the tax law. Note, though, that even if we factor in these investors, the basic analysis still holds but the impact will be lightened. In fact, one way to alter the analysis is to take a weighted average tax rate across all investors in the market, which would buffer the impact. The graph below estimates the effect on the market, stocks with a dividend yield of 4% and stocks with a dividend yield of 0% of assuming lower tax rates in the post-cliff period.
3. Investors may already have built in the expectation that tax laws will change into current stock prices: To the extent that the fiscal cliff has been in the news and widely reported, it is possible that the market has already incorporated the possibility of it coming to fruition into stock prices and the expected return. I would have been inclined to believe this if I had seen the equity risk premium climb, and stock prices drop, over the course of the year, but they have not. In fact, we started the year with a much higher equity risk premium of 6.04% and have seen the premium drift down to 5.75%.
4. Companies may change their dividend policy: I did predicate my analysis on companies maintaining their dividends at 2012 levels, even if the tax law changes to tax dividends more highly in 2013. In fact, if companies were completely flexible, they could stop paying dividends and largely nullify the impact of the tax law change. History suggests that this is unlikely. If there is a word that best describes dividends, it is that they are "sticky", i.e.. that companies are reluctant to change dividends and especially to cut them. In fact, the 2003 law did not to lead to a surge in dividends (though a few companies pay special dividends in the immediate aftermath) and I don't think that a reversal of the law will lead to a sudden reassessment of dividend policy.
I may be overly pessimistic, but the dividend cliff scares me and I am planning for the eventuality that the tax code will change drastically on January 1, 2013. I am and will continue pruning my portfolio, shifting my money from large dividend-paying US stocks to non-dividend paying or low-dividend paying foreign stocks. I won't go overboard and sell short/ buy puts on high dividend paying stocks. After all, the dividend tax effect is one of many forces that will affect equity markets over the next few months and it is possible that one of these effects will drown out the tax effect.