Tax Hike on Dividends: 15% to 43.4%?

Is Wall Street ready for a tax hike on dividends?

SmartMoney's Jack Hough had an interesting article on March 26, 2012 discussing how despite Apple's recent dividend announcement, "bad news might be lurking around the corner." Hough: "Unless Congress takes action, the top tax rate for the highest earners on most dividends, currently 15%, is set to jump to a whopping 43.4% next year. That is a maximum income-tax rate of 39.6% -- since dividends will once again be taxed as regular income -- plus a 3.8% tax on investment income as part of the health-care overhaul passed in 2009."

Hough's analysis suggested that in light of the impending tax hike, investors may be leery of dividend-paying equities. As such, for high-dividend stocks "the fear is that their prices will fall sooner than later." Hough discussed that investors who prefer high-dividend stocks "could protect themselves in the short term by placing options bets on a broad decline in dividend-paying shares." Even so, Hough noted that such a strategy is expensive in effectively paying for insurance on high-yield stocks. Alternatively, investors may want to look toward stocks "that promise to boost their dividend payments over those that merely have the largest" yields.

Hough noted that in taking into account the historical averages of dividend-paying companies and dividend payments, "there is plenty of room for more and bigger [dividend] payments." According to S&P senior index analyst Howard Silverblatt, "dividend spending by S&P 500 companies should increase 15% this year."

With respect to taxes on dividends, Hough commented that "[n]o one knows how the politics will unfold." Despite political uncertainty, UBS UBS chief equity strategist Jeremy Zirin "guesses ... that politicians will settle for 'the path of least resistance' with another short-term extension of the cuts" at some point after the 2012 election. That being said, Hough commented that "investors should assume higher dividend taxes are coming and focus on the likely fallout."

Even if the tax hike comes, "dividend floodgates won't necessarily slam shut in response to higher taxes come 2013 or beyond." Whereas a dividend tax hike "would affect only a small percentage of the population", US Bank's Jim Russell suggested that such a tax hike's effects on the broader market would be limited. Hough also discussed an analysis from Bank of America Merrill Lynch's Savita Subramanian that found "no evidence that the change in the dividend-tax rate had any significant impact on the relative performance of dividend-oriented strategies." Hough: "Subramanian found that dividend growth matters much more than tax-rate changes in determining future stock prices."

Thus, investors may want to look more to the course of companies' dividend payments "with moderate yields and steady payment growth" rather than present yield levels. Vanguard Group's Joel Dickson said that "with or without the threat of a dividend-tax increase, investors with a dividend-heavy portfolio should consider balancing their approach by adding something as simple as a broad-market index fund."

I recently discussed the prospect of additional taxes in light of growing income inequality and concentration of wealth in the US. In that article, I mentioned a recent report from NPR discussing changes in marginal tax rates and capital gains taxes. The NPR report noted how while the top income tax rate went down under Reagan, this change came with a higher tax on investment income. From the article: "Bill Clinton restored the tax advantage for investment income, and George W. Bush made it bigger. Today, qualified dividends and capital gains are taxed at just 15 percent, less than half the top tax rate for ordinary income." Such changes illustrate not only differences in economy, but also differences in cultural attitudes toward taxation.

In light of the report from NPR, maybe there is room for tax rate increases after all. Even so, on this topic one cannot help but think of the Laffer curve, which suggested that there are boundaries to a government's ability to raise revenue via taxation. In light of the Laffer curve, when it comes to tax rates and government revenue, sometimes less is more.

Given the political sensitivities of income inequality, ongoing issues related to the Affordable Care Act, and various other factors including unemployment and the student loan bubble, the specter of tax hikes in the public discourse should come as no surprise. That being the case, per Hough's aforementioned analysis, the realm of the political is spilling into the realm of the financial to the point where the massive changes in national health-care policy come with heavy tax implications for top earners on Wall Street. At a time where Wall Street, Main Street, and Washington would appear to be at odds with each other in a very delicate tripartite socio-economic balance, it is as if (in addition to unemployment, rising gas prices, rising living expenses, et al.) one could add tax hike fears to the list of possible economic headwinds facing the US economy.