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The Dividend Bust?

A close look at the effect of the dividend tax cut reveals a disappointing investor reaction.
Fortnightly Magazine - October 15 2003

a slower rate than earnings. Thus, while earnings growth reflects the actual growth of the firm, dividend growth reflects a change in utilities' payout policies. Value Line projections still show a continued decline in payout ratios for utilities though these projections were made after enactment of the dividend tax reduction legislation.

Price Reaction

Since the dividend payout of electric and gas distribution utilities is higher than that for stocks in general in the United States, if the tax law change were to notably influence prices, utility stocks would be expected to rise sharply compared with general stock indexes. Any analysis of stock price changes, however, is confounded by the fact that there were numerous conflicting proposals concerning dividend taxation advanced in the year or so before passage of the act, and it is therefore difficult to ascertain exactly what investor expectations of dividend tax cuts were impounded in stock prices at differing times. During the course of the debate on tax law changes, it was not entirely clear to investors whether there would be no reduction in the dividend tax, elimination of the entire dividend tax that investors paid, or something in between.

Table 2 (p. 47) compares the stock price changes of the Standard & Poor's 500 Index with the changes for electric utilities and gas distribution utilities covered by . Three periods are analyzed: (1) the year since President Bush expressed interest in reducing the dividend tax; (2) the first seven months of 2003; and (3) the two months (June and July 2003) after the tax reduction legislation was enacted. Table 2 indicates that, in general, utilities have not outpaced most other stocks. While it is difficult to reach definitive conclusions about relative stock price changes at any time, the ambiguity as to what dividend tax changes were impounded in stock prices over these various periods further confounds the effort.

Constraints on Stock Price Increases

Utility stock prices may not go up much as a result of the dividend tax change, for a variety of reasons.

  1. Many investors cannot benefit from the new dividend tax reduction. The dividend tax reduction has value to investors only if they must pay taxes on the dividends they receive. However, about half of all dividend payments go into tax-exempt or tax-deferred accounts such as charities, pensions, and IRAs. 1 This fact alone would tend to moderate or obscure investor (and company) reactions to the dividend tax reduction.
  2. The dividend tax reduction has a sunset provision. Both the capital gains tax reduction to the 15 percent level and the dividend tax reduction to the 15 percent level are scheduled to expire at the end of 2008. 2 Given the uncertainty about future tax policy regarding dividends, companies and investors might move cautiously, if at all, in response to the dividend tax reduction. This is because companies and investors base their payout policy and investment strategy, respectively, on long-term considerations. Investors would not want to switch from growth to income stocks if they thought the tax reduction for dividend-paying stocks might disappear in a few years.