The Dividend Bust?

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 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.

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.

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. 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.

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.

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.

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 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 has only been a few months since the passage of the act and investor evaluations and planning may not have yet fully settled down. However, given the factors discussed above, the dividend tax reduction is likely not going to be the slam dunk many thought it might be for utilities.

"Review & Outlook: Ending Double Tax Trouble," , Dec. 26, 2002, p. A14.

In legislative parlance, a "sunset provision" means that a law is automatically repealed (or expires) on a specific date unless specifically reauthorized.

See Richard Stavros, "Double Taxation Repeal: Fire or Ice?," Public Utilities Fortnightly, Jan. 15, 2003, p. 15.

See Richard Stavros, "The Dividend-Centric Universe," Public Utilities Fortnightly, June 15, 2003, p. 16.

The Congressional Budget Office's August 2003 Budget and Economic Outlook estimates that the 2004-2008 budget deficit will be more than $1.4 trillion.

While IRS regulations concerning the eligibility for the new lower tax rates for dividends have not been finalized as of this writing, it appears that dividends on trust preferred securities will not qualify for the lower tax rate. See Jeff D. Opdyke and Tom Herman, "Wall Street Pushes Preferred Stock," , Aug. 19, 2003, p. D1.

Patrick McGeehan, "A Chance for Utilities to Clean Up Their Act," The New York Times, Aug. 24, 2003, p. 6.

Salient Changes

For investors, the salient changes in "The Jobs and Growth Tax Relief Reconciliation Act of 2003" are:

a reduction in income tax rate brackets (the top rate was reduced from 38.6 percent to 35 percent);

a reduction in the maximum tax rate on capital gains from 20 percent to 15 percent; and

common stock dividends formerly taxed at the personal income tax rate (which went as high as 38.6 percent) are now taxed at a maximum of 15 percent.¹

Lower income taxpayers have to pay only a 5 percent tax on both capital gains and common stock dividends.

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