Dividend Debacle


Investors get caught in partisan crossfire.

Fortnightly Magazine - October 2010

It’s almost impossible to discuss dividend taxes without siding with one partisan political camp or the other. If you want to cut dividend taxes, you’re probably a Republican. You believe the private sector is more effective at deploying capital than the public sector is, and dividend taxes—like all forms of investment taxation—take money away from private investors and put it into government hands.

On the other hand, if you want to see dividend taxes raised, then you’re a Democrat. You believe dividend and capital-gains taxes are inherently progressive forms of taxation, lightening the load for lower and middle income taxpayers and shifting it toward those who spend a smaller share of their income on basic necessities.

Few economic issues are so simple, however, that they can be reduced to a binary choice between pure capitalism and progressive interventionism. Dividend taxes are no exception, with cogent arguments for and against extending the 2003 tax cuts—which reduced the rate for dividends in the highest tax bracket from 39.6 percent to 15 percent, and lower rates for other brackets.

Lawmakers on both sides of the aisle agree that the 2003 tax cuts shouldn’t simply be allowed to expire. Where they disagree is on policy going forward. The Obama administration proposes to adjust the highest tax rate to 20 percent—higher than the current 15 percent, but about half of the pre-2003 rate. Obama’s Republican opponents want a full extension of the same rates for all tax brackets. Many Democratic lawmakers agree with their Republican colleagues, and others would support the Obama proposal. Only a few want to see the pre-2003 rates reinstated in whole.

Unfortunately, during this year’s mid-term campaign, politicians on both sides of the aisle are behaving more like unruly kids than national leaders; they’re more interested in an ideological food fight than they are in cooperating to forge rational economic policy. And that’s a shame, because Congress’s failure to compromise on this issue might put America’s utility industry at something of a disadvantage in the capital markets—just as companies are preparing to finance a historic wave of construction in job-creating domestic infrastructure.

Fortunately, food fights never last forever. This particular battle will end sometime around 9 a.m. on November 3. And early next year, the uncertainty about dividend taxes will dissolve when lawmakers re-convene to clean up their mess.

Tax Facts

Dividend taxes make for juicy sound bites in the national media. Conservatives argue that taxing investment income discourages people from putting their capital to work, sending a counter-productive economic signal. In today’s shaky economy, raising taxes seems like a questionable idea for any income group—least of all those who are investing in capital-intensive, offshore-resistant industries like utilities. Republicans on the campaign trail are using this argument to justify stonewalling Obama and the Democrats.

Meanwhile, progressives point out that tax cuts for rich people produce a smaller multiplier benefit for the economy than other budget options do. Congressional Budget Office (CBO) statistics show, 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 (www.defendmydividend.org), 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 proposal to keep the tax cuts intact for all taxpayers except those earning more than $200,000 a year.

With that kind of pressure from within their own party, House Democrats seem destined to pass a compromise tax bill in the lame-duck session that preserves most, if not all, of the 2003 tax cuts. At a very minimum, the highest tax rate for dividend income won’t rise beyond the top rate for capital gains.

So when the food fight is over, and the politicians get back to work, the industry’s worries might seem a bit overblown in hindsight. The practical effect for utilities will be virtually nil, even if rates go up for some taxpayers.

As Josh Peters, editor of Dividend Investor, told Morningstar’s Jeremy Glaser in a webcast earlier this year, “Dividends didn’t start to work for investors only in 2003, when the current tax treatment was brought about. Dividends have been working for investors and stocks for centuries.”