Stocks dropping off due to dividend tax unlikely

By DAVID MOON, Moon Capital Management, LLC
May 27, 2012

A recent Wall Street Journal column by Trend Macrolytics’ Donald Luskin warned of stocks falling as much as 30 percent next year.

Luskin’s piece is provocative reading and inspires an interesting intellectual exercise. His conclusion may or may not be correct. His reasoning however, is mostly hyperbole, leading to falsely determined worry.

Unless Congress amends current law, on January 1, 2013 the top tax rate on dividends will rise from 15 percent to 43.4 percent. This is due to the expiration of the 2001 law lowering dividend taxes to 15 percent, combined with a 3.8 percent Obamacare surtax on all forms of investment income, including dividends.

The panic in the Wall Street Journal piece assumes that the 2001 dividend tax rates will necessarily expire without amendment. Although theoretically possibly, the thought that Congress would increase taxes on dividends for all taxpayers from 15 to 43.4 percent during an election year is ludicrous. The likelihood of such a tax increase is not enough to justify predicting stocks dropping off a cliff in seven months.

The dividend doom-and-gloomers also assume that most or all taxpayers will owe the 43.4 percent tax on their 2013 dividends. This ignores tax-deferred investors like pension plans and other retirement accounts. Many studies suggest that probably only 25 percent of investors pay tax on currently received dividends.

It is much more likely that taxes on dividends and income would increase for certain taxpayers, but not all. This would reduce the percentage of taxpayers who pay the higher rate from 25 percent of investors to an even smaller number.

The author states that companies pay dividends in order to attract capital, so higher tax rates will require lower stock prices to provide investors the same after-tax yield. That sounds nice in theory, but simply isn’t true.

Corporate dividend policy is multifaceted and complicated. A company may choose to pay a dividend for many reasons in addition to simply trying to attract capital.

Wal-Mart pays a dividend. It hasn’t issued stock, however, in years. The amount of dividend it pays has nothing to do with, in Luskin’s word, the “after tax yield required to attract capital.”

Net income is what remains from revenues after a company pays its expenses. A company has options with respect to its excess revenue. It can pay dividends. It can choose to retain the earnings for future use. Some companies use excess operating cash to rearrange their balance sheet by paying down debt or repurchasing shares of stock in the open market. All of these create value for shareholders, even if they don’t arrive in an envelope in the form of a quarterly dividend check.

If the Federal government does choose to tax all dividends at some ludicrously onerous rate, companies will simply provide that cash to their shareholders in other forms such as share repurchases.

Higher dividend taxes – of any amount – certainly are no benefit to the stock market. But it is silly to predict a 30 percent price drop on that possibility.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Click here to subscribe to MCM commentary.

MCM website