Friday, November 03, 2006

Should an Investor Worry about the 2010 Expiration of the Reduced Tax Rate on Dividends?

Congress has extended the 15% tax rate on qualified dividends to 2010. Would its expiration impact the market performance of dividend paying stocks?

First one needs to look at the impact on equity performance with the initial passage of the 15% tax rate on dividends contained in the Jobs and Growth Tax Relief Act of 2003. The Federal Reserve publish a paper in 2005 reviewing the impact on equity prices leading up to and following passage of the tax reduction act. In short, some state equity prices do not seem to have been greatly impacted by the reduced tax on dividends. This would seem a surprise since investors should be attracted to stocks paying a larger after tax dividend.

(click on graphs for larger image)

It is rare that one can point to a single factor when determining the movement of stock prices. The Federal Reserve paper notes President Bush’s Iraq ultimatum occurred on March 17, 2003. This was just two months after the President’s announcement of his tax cut proposal. The President signed the bill on May 28, 2003 and many articles discussed the favorable impact this bill would have on dividend paying stocks. A stock market rally did ensue in January 2004, but was short lived when Alcoa reported disappointing 4th quarter results.

In a Department of Treasury report dated March 14, 2006, it is noted “while numerous factors contributed to the rise in stock prices during the past three years, the dividend and capital gains tax cuts likely played an important role. One study estimated that the likely increase in aggregate equity values due to capitalizing the annual flow of permanent dividend and capital gains tax cuts would be 6 percent. Given the forward looking nature of the markets, it is not clear exactly when the effects of the dividend tax cut were capitalized into share prices or what the expected duration of the tax cut was. Assuming that the increase in equity values due to the tax cut occurred entirely in 2003, then as much as one-quarter of the 26 percent increase in the S&P 500 index for 2003 could be attributed to the capitalized value of the dividend and capital gains tax cut. This estimate is rough and ignores the influence of the tax cut on future investment behavior.”

The data is mixed on what has contributed to the strong market performance since the tax cut. What is certain is economic growth did improve subsequent to the passage of the tax reduction act.

Percentage Change in Real GDP over the Previous Period

Additionally, more companies began paying a dividend subsequent to the passage of the reduced tax rate on dividends.

Percent of Firms in the S&P 500 Paying Dividends: 1980-2005

So the question of whether a change in the tax paid on dividend distributions is an important one; however, the fundamental cash flow of companies has a larger impact on stock prices. With a change in the tax rate on dividends, the operating cash flow of a particular company remains unchanged, unless economic growth slows. The benefit of using a dividend growth discipline in selecting equity investments by an investor is this procedure enables the investor to gauge the operating stability of a company. Focusing ones investment analysis on companies that have ten or more years of consistent dividend growth likely mitigates the potential impact of dividend tax changes.

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