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Dividend Debacle

Investors get caught in partisan crossfire.

Fortnightly Magazine - October 2010

for example, that cutting investment taxes by $1 produces less than 30 cents of net economic benefit, compared to the $1.25 gained from spending $1 on unemployment compensation. In short, Democrats accuse their Republican opponents of protecting fat-cat investors at the expense of unemployed workers.

But outside the partisan debate, one fact seems indisputable: Higher investment taxes raise the cost of capital—not just for utility companies, but for any company that finances its business with public equity or debt.

By reducing investors’ all-in returns, investment taxes—whether levied on dividends or capital gains—make investments less profitable for stockholders and bondholders. Over time, this translates into higher costs of capital for companies that issue those securities. To recoup returns lost to taxes, investors demand more for their investment dollars, driving bond coupon rates upward and driving share prices downward.

Dividend taxes are especially problematic for regulated utility companies, which pay out a large share of their net earnings to investors in the form of dividends—frequently 60 percent or more. To the degree changes in tax law impose greater taxes on dividends than they do on capital gains, effective yields will erode for dividend-paying stocks compared to other investments. Utilities’ capital costs would increase, perhaps substantially—and that’s exactly what will happen if Congress allows the 2003 tax cuts to expire on Dec. 31, 2010.

These facts aren’t in dispute. Nevertheless, Congress hasn’t done anything about it, because it might mean conceding political capital in a rancorous election cycle.

Much Ado

For the past several months, the investor-owned utility industry has lobbied hard to preserve status-quo tax rates. Through public speeches, appearances on TV talk shows, direct lobbying, and Internet campaigning via Twitter and a dedicated website (, the Edison Electric Institute and its members have been spreading the word about rising dividend tax rates.

The issue has brought the industry together unlike anything in recent memory—in part because we want to protect our low costs of capital, and also to prevent an uncomfortable scene at the next shareholders’ meeting.

But while concerns about shareholders’ reactions might be well founded, the actual likely effect on companies seems quite small. Even if Congress does nothing, dividend taxes won’t simply spike for all shareholders. Instead, “qualified dividends” will cease to exist, and dividend income will be taxed like any other income, at whatever rates apply under the federal tax brackets.

In this do-nothing scenario, the top marginal tax rate would be 39.6 percent for those earning $374,000 a year, but most taxpayers (more than 95 percent, according to a Brookings Institution report) would continue to pay much lower rates. The highest capital-gains tax rate would return to 19.6 percent, nominally making dividend-paying stocks less attractive for investors with the highest taxable incomes.

The do-nothing scenario, however, seems increasingly unlikely, even amid the campaign-season chaos. A group of 31 Democratic members of Congress sent a letter on September 15 to Speaker Nancy Pelosi and Majority Leader Steny Hoyer, asking them to support legislation extending the 2003 tax cuts. Such legislation would go even further than the president’s