Dividend Double-Take


What happens when the Bush tax cuts expire?

Fortnightly Magazine - October 2012

While putting my thoughts together for this editorial, I was tempted simply to re-publish the text from my October 2010 column, “Dividend Debacle.” That piece could stand nicely in this space with just a few changes—namely, today we’re approaching a presidential election, not the mid-terms. But aside from that, Congress again is embroiled in another hyper-partisan food fight that threatens to blow up into a fiscal crisis. And once again dividend-paying companies like utilities are caught in the crossfire.

However, since 2010 two things have happened that alter the tax-policy calculus. First, the Occupy movement seized public attention away from the TEA Party’s fiscal-responsibility agenda and turned it toward the cause of economic fairness. Then, this year the Republican party chose for its presidential ticket Mitt Romney—historically a political moderate, yet vulnerable to being defined as a fat cat. With his equity-fund background; his wife’s multiple Cadillacs; and his dismissive remarks about a certain 47-percent of Americans, Romney arguably has put some members of Congress in a position where they can’t vote to extend the Bush-era tax cuts, even if they want to, because doing so would add ammunition to the class warfare that’s come to dominate the budget debate.

Where does that leave the utility industry? It leaves us facing the strong likelihood of a dividend tax increase, that’s where.

Cutting a Deal

In September, a joint tax committee brought together a bipartisan group of legislators to chart a path that would avoid the so-called “fiscal cliff”—i.e., the set of automatic federal spending cuts that would take effect if Congress fails to reach a budget compromise. Although nothing truly definitive emerged from those meetings, two general themes seemed to dominate, if we can trust the comments we heard from lawmakers in the days that followed. First, despite all the campaign-trail bluster, few in this Congress seem to have the stomach for another budget crisis. Party leaders are hinting toward a budget extension in the lame-duck session that would push the problem into the next term, perhaps packaged with a less-draconian substitute for the “sequester” contingency that Congress produced back in 2010. Second, unlike the last time, tax increases now are on the table—even for TEA Party Republicans like Sen. Jim DeMint (S.C.), who said in September, “We might as well cut a deal. If Republicans want to maintain the defense, we’re going to have to give tax increases to Obama.”

Such a deal could involve extending the Bush-era tax cuts into the middle of 2013, and then rolling them back, perhaps according to some progressive formula that favors lower- and middle-income taxpayers. Alternatively—although much less likely—Congress might let the tax cuts expire for investment income, in which case dividends and capital gains would cease to qualify for a special tax rate, and instead would be treated as ordinary income.

That’s bad news for utility investors, particularly those in the upper income brackets who will see the IRS take a much bigger bite of their dividend income—as much as 39.5 percent for the very top tier. For people in lower tax brackets, the cost will be more moderate, depending on how Congress handles the issue. Under the do-nothing scenario, in which the tax cuts are allowed to expire, a person whose ordinary income is taxed at 15 percent would see his or her dividend taxes rise from 0 percent—where they’ve been since 2008 under the current tax code—to the full 15 percent rate.

So allowing the dividend tax cuts to expire will weaken the value proposition for utility stock. How severe the effect will be, however, is a subject for debate among analysts.

Double Taxed

In an interview for this issue’s cover story (“Last Call”), Morgan Stanley’s David Nastro stated that utility price-to-earnings (PE) multiples could get squeezed by 1 to 1.5 percent, if the dividend tax cuts are allowed to expire. That estimate factors dividend taxes along with a separate 3.8-percent Medicare tax on net investment income, assessed in the 2010 Patient Protection and Affordable Care Act—a.k.a., “Obamacare.” Such a substantial effect on stock prices would cause a major loss of value for the utility industry.

However, other analysts are more sanguine about dividend taxes. One investment banker noted that dividend tax rates are applied evenly across all yield-oriented investments, and so utility stocks won’t be any more disadvantaged in the market than comparable choices will be. “Given how low Treasuries are right now, letting the tax cuts expire won’t be a big deal,” the banker told Fortnightly. “There are only so many stocks that produce low-risk yields like utilities do.”

Plus, utilities have other ways to deliver returns to shareholders, such as share-repurchase programs, if investors actually start to shun dividend-paying stocks. But that seems unlikely. Dividends have served utility investors well for decades, under much more onerous tax regimes, and they’ll continue doing so even if the tax cuts expire. Indeed, a recent report by Copeland Capital Management quantified the effects of dividend tax rates on the behavior of both investors and corporate management, and found virtually no correlation. “Corporate dividend policy,” the report stated, “similar to the relative performance of dividend-oriented investment strategies, is more likely to be a function of the stability of corporate cashflows and the economic cycle than tax rate changes.”

Interestingly, the Copeland report concluded by identifying a fundamentally stronger argument against dividend taxes generally: the fact that they represent double taxation. Dividends are paid from after-tax income, so shareholders—who, after all, own the company—shouldn’t have to pay taxes on that same income again. But as Copeland notes, few legislators have argued this principle—perhaps because they know it opens up a broader debate about corporate taxes, which could further reduce the number of politically viable tools available for cleaning up the government’s fiscal mess.