[BETA] Fortnightly

A close look at the effect of the dividend tax cut reveals a disappointing investor reaction.

 

While some predicted a very significant increase in price for utilities if dividend taxes were reduced, the actual price change data show a rather different picture.

Legislation enacted earlier this year substantially reduced the income tax investors pay on common stock dividends. Some analysts projected that this tax law change would lead to a sharp increase in utility common stock prices. After all, utilities have been thought of as income stocks-providing among the highest levels of dividend payout in the U.S. economy. Therefore, in theory, utility investors would have much to gain from a substantial dividend tax reduction. An easy slam dunk! Or was it?

In fact, utility investors have not responded as might have been expected. What explains this?

Breaking It Down

"The Jobs and Growth Tax Relief Reconciliation Act of 2003" ("the act"), was signed into law on May 28, 2003.

Three reasons for changing the rate of dividend taxation should be highlighted. First, prior to enactment of this legislation, the tax code was looked on as favoring growth stocks over income stocks because capital gains were taxed at a lower rate than were dividends. With both dividends and capital gains being taxed at the same level-15 percent-the tax code is now neutral. Second, the law reduced the double taxation of dividends. Common stock dividends are not tax-deductible to corporations, and thus companies pay income tax on such dividends at the corporate level. Investors then would pay personal income taxes on the common stock dividends that they received-thus the "double taxation" of dividends. While the new act did not eliminate double taxation-investors still pay a 15 percent tax on dividends, even though corporate income tax has already been paid on those dividends-it does bring down the level of double taxation substantially. Third, it was thought that the change in dividend taxation would encourage more conservatism in companies-a refreshing change after the spate of corporate governance scandals over the past few years. Since dividends must be paid from actual cash on hand, if the act encouraged companies to initiate dividends or increase dividends, then they would operate more conservatively than some of the high-flyer business models used in recent years.

Payout Ratio Trends

Table 1 (p. 47) shows a 10-year history of the trend of payout ratios for electric utilities and gas distribution utilities. Table 1 also shows the median Value Line payout ratio projections for these utilities for the near future. (Payout ratios reflect common dividends per share as percent of earnings per share.) In the early 1990s, both electric and gas distribution companies had payout ratios close to 80 percent. Since that time, the payout ratio has trended downward, especially for electric utilities. Value Line projects that the downward trend will continue into the near future, reaching the 50 to 55 percent level. For whatever reason (possibly a greater need for internal generation of cash or concern about the higher risk of earnings fluctuations), utility companies have been increasing their dividends at