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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
  1. Similarly, companies might not want to change their long-term dividend policy to please investors if the tax considerations driving such action might be reversed within a few years.
  2. The dividend tax change may cause utilities to lose their income-stock "edge." Utilities have often been regarded as "income stocks"-having a relatively high level of dividends setting them apart from many other industries. With the reduction in the dividend tax rate, many non-utility companies may start paying significant dividends, thus diluting or eliminating the income-stock "edge" utilities have over competing investments.
    In early 2003, Paul Donahue, a managing director of Global Power & Utility Capital Markets at Morgan Stanley, stated in that a dividend tax reduction might lead to utilities having more competition, instead of them rising to the top. Donahue wondered what might happen if tax relief led big industrials or cyclical tech companies like Microsoft to start paying out larger dividends. He said some believe that utilities could lose their staple as the go-to income investment for widows, orphans, and the upcoming wave of retiring baby boomers looking for safe stocks. 3
    Mr. Donahue's musing was certainly prescient in one regard. Microsoft announced the initiation of a dividend payment in the first quarter of 2003. While the payout ratio is a modest 8 percent and the dividend yield is less than 1 percent, the Microsoft example shows that there may be many more instances where investors can buy stocks that throw off some cash and yet also offer the possibility of significant growth. According to S&P, a surge in the number of dividend-paying companies in the S&P 500 Index has reversed a 20-year decline in the number of companies in the index paying a dividend. For the first seven months of 2003, the S&P 500 Index had 171 dividend increases and initiations, compared with 113 in 2002. The prospect of other companies initiating dividends or raising their dividend payouts may substantially lower the income stock advantage that utilities currently have over other investments.
  3. The capital gains tax rate is equal to the dividend tax rate. While much attention has been focused on the dividend tax reduction aspects of the act, the level of dividends is merely one factor among many analyzed by investors in forming their opinions as to the desirability of an investment. 4 It is important to remember that the capital gains tax rate is now equal to the dividend tax rate. Thus, at the personal tax level, there is a neutrality between dividends and capital gains. While dividends have the advantage of reflecting "a bird in the hand," they have the disadvantage of creating a tax liability in the year they are paid. In contrast, capital gains can be deferred-gains do not have to be realized and the capital gains tax paid until a time of the investor's choosing. This ability to defer taxes can be a significant advantage for investors.
  4. The cost of utility debt and preferred stock may rise. The tax cuts enacted in May 2003 are projected to widen the budget deficit. 5 This could possibly