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...
The Dividend Bust?
- lead to higher interest rates in the future that would have two adverse effects on utilities. First, since utility common stocks are thought to be interest-rate sensitive, an increase in interest rates could lead to a decline in utility stock prices, other things being equal. Second, an increase in the general level of interest rates could raise the cost rates for new debt and preferred stock for utilities.
There is also a direct tax-related reason that the cost of new utility debt and preferred stock may increase. Interest income is fully taxable to the investor at the investor's personal income tax rate. In contrast, common stock dividends and capital gains are now taxed at a maximum of 15 percent. This tax disadvantage for interest payments to the investor could have the effect of raising the cost of new debt to utilities.
The taxability of preferred stock dividends of utilities is more complicated because there are two types of preferred stocks that utilities use: "traditional" preferred stock and "trust" preferred securities. Trust preferreds are a hybrid type of security comprised of a preferred stock and a debt security. The ultimate effect of this combination is to make a company's dividend payments on this security tax deductible at the corporate level, whereas without the hybrid combination it would not be so. Recall that one of the purposes of the act was to reduce double taxation of dividends. Since no taxes are paid at the corporate level for trust preferred dividends, even under the new act investors must pay the full personal corporate income tax rate on dividends received from trust preferred securities. 6 Thus, since common stock dividends and capital gains will be taxed at a lower rate than trust preferred dividends, utilities may find that the cost of issuing this type of security will increase in the future, other things being equal.
- Holding utility stock in tax-deferred accounts is less attractive. The tax that investors will ultimately have to pay on withdrawals from a tax-deferred account is now much higher (up to 35 percent) than the taxes investors have to pay on dividends and capital gains (a maximum of 15 percent) in taxable accounts. This could make holding utility stocks less attractive in tax-deferred accounts, and it could possibly have a downward effect on utility prices. Investors likely do not, and should not, make investment decisions purely on the basis of tax law changes. This is especially true considering the sunset provision built into the act. Thus, since the act has surely made rational long-term planning for investors more difficult, it is not entirely clear what affect this particular result of the tax law change may have on utility stock prices.
The Bottom Line
In commenting on how the tax cut on dividends affected returns on utility stocks, John Kohli, manager of the $1.6 billion Franklin Utilities Fund stated: "People seem to have forgotten it. Since the beginning of June, the electric utility industry has underperformed the Standard & Poor's 500 by about 10 percent, despite renewed emphasis on dividends." 7 Admittedly it