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What Happens to Dividends After the Fiscal Cliff?

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If Congress does nothing -- and Congress is great at that -- most Americans will see their tax bills rise on Jan. 1. It's part of the fiscal cliff, a deep combination of tax increases and spending cuts that are the result of how existing laws, some more than a decade old, were designed to play out.

One of those tax increases could hit dividends. The top dividend tax rate is now 15%, where it's been for the past decade. Come Jan. 1, dividends could revert to being taxed as ordinary income. And income-tax rates are set to rise themselves. Add it up, and if you're in a top tax bracket, dividend tax rates could be just north of 40% in less than three months.

Before you freak out, odds are that most of the fiscal cliff will be avoided with a last-minute deal hammered out by Congress. But no one really knows. And many are starting to wonder: What happens if dividend taxes actually jump to more than 40%?

Here's what: If you're in a high tax bracket and you earn a lot in dividends, your tax bill will go up. There. Easy enough.

A bigger question is how companies might change their dividend policies. If taxes rise, dividends aren't worth as much to shareholders. That might entice companies to instead use cash for things like share buybacks and acquisitions, the thought goes.

Jason Zweig of The Wall Street Journal gave an example of how companies plan around impending tax policies:

There is some precedent for doing shareholders a favor by paying out income before it becomes taxable at a higher rate. Two years ago, when Congress also looked likely to jack up taxes on dividends, roughly two dozen companies, including Sara Lee, accelerated their January 2011 payouts into December 2010.

But Zweig doesn't seem to buy the argument that dividend payouts are doomed to fall if dividend taxes jump. He points out that taxes used to be considerably higher than they are now, yet companies paid out considerably more dividends as a percentage of income.

I used data from Yale economist Robert Shiller and the Tax Foundation to show what he means:

Note: I excluded half of 2008's dividend payouts, when earnings collapsed and the payout ratio spiked to more than 300%. Including it would make the chart difficult to read.

Both top dividend tax rates and dividend payouts are near historic lows.

Now, very few people actually paid the confiscatory tax rates of the 1960s, '70s, and '80s. Tax shelters, deductions, and credits drastically lowered average effective tax rates. But a version of that is also true today, as the Tax Policy Center explains: "About half of all corporate dividends are paid to investors that don't pay tax -- pensions, non-profits, foreign entities, and the like. Changes in the dividend tax rate don't affect their tax bills."

Economist Jesse Edgerton also gives a rebuttal to the idea that the 2003 dividend tax cut had much to do with the accompanying rise in dividends:

Recent literature has claimed that the 2003 U.S. dividend tax cut caused a large increase in aggregate dividend payouts. I document four simple facts that call this claim into question. First, the post-tax cut increase in dividend payouts coincided with a surge in corporate prots, such that the dividend payout ratio did not rise. Second, share repurchases increased even more rapidly than dividend payouts. Third, dividend payouts by Real Estate Investment Trusts also rose sharply, even though they did not qualify for reduced taxation.

Again, amid historic low dividend taxes, corporations have been pretty stingy with payouts in the grand scheme of things.

I'm generally not supportive of higher dividend taxes. For most, they're high enough, the double taxation argument has merit, and if tax revenue is what you're after, removing some of the insane deductions and loopholes that are in place would raise more money while distorting less behavior.

But the evidence we have suggests it's unlikely that dividend payouts would change much if we go over the fiscal cliff. And more broadly, the idea that corporate devastation awaits if we return to policies that prevailed in the 1990s -- when, by nearly any measure, the economy was markedly stronger -- should rank low on your list of worries. Real low.

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Fool contributor Morgan Housel and The Motley Fool have no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (4)

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  • Report this Comment On October 15, 2012, at 9:01 PM, DividendsBoom wrote:

    I doubt it will affect the dividend stalwarts, but probably would give others another excuse to not pay dividends, not that they would have otherwise.

  • Report this Comment On October 16, 2012, at 11:23 AM, mdk0611 wrote:

    Question. To what extent, pre-1990's were companies doing share buybacks? In particular, back in the 50's and 60's. Is this a cultural/philosophical change that needs to be taken into account?

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