Dividends have become one of the most important attributes investors look for in a promising stock. But if we go over the fiscal cliff -- or even if a cliff solution doesn't reverse 2013's tax rules for all taxpayers -- then companies that have gotten onto the dividend bandwagon in recent years might find themselves heading for the exits.
What the cliff will do
Unless lawmakers can agree on a way to avert the fiscal cliff, on Jan. 1, tax rates will change dramatically. For ordinary taxes on wages, investment interest, and other forms of ordinary income, top rates will rise from 35% to 39.6%. Add on the 3.8% Medicare surtax that will go into effect next year, and the total rate that a top-bracket taxpayer will face will be 43.4%.
That may seem like a big hike, but it's nothing compared to what dividend investors will see. With current maximum rates on dividends of 15%, 2013 tax law would completely take away the preference for dividend income, sending taxes all the way up to the same 43.4% rate that applies to ordinary income. In other words, while wage income would see a modest tax increase, taxes on dividends would nearly triple.
That proposed jump has led to a huge number of special dividends and payout accelerations into 2012. But if those higher taxes do take effect, the more important question will be whether dividend-paying stocks do an about-face and reduce their payouts, seeking more tax-efficient ways to return capital.
The way it was
To get a sense of what's most likely, it makes sense to look back to past periods during which dividends were out of vogue. A 2002 study (link opens PDF file) published in The Journal of Finance found that from 1980 to 2000, the amount of money that companies spent on share repurchase programs rose from less than 5% to almost 42%, with average annual growth rates of 26% on buybacks far outpacing the less than 7% growth in dividends. By 1999, industrial companies spent more on share repurchases than on dividends -- the first time in history that had occurred.
So why did dividends go out of style? It certainly wasn't because investors stopped wanting income from their investments. Rather, it came down to a simple question of economics: With tax rates of dividends higher than tax rates on capital gains, it made more sense for investors to have their companies make share buybacks, selling shares to generate cash when needed. Any gains would result in less tax than the corresponding amount of dividend income.
Conversely, when tax cuts took effect in the early 2000s, the rates on dividends and capital gains became equal. That eliminated the advantage that buybacks had over dividends, and when shareholders clamored for more income in light of falling interest rates on fixed-income alternatives, companies were in a better position to deliver by raising their payouts.
What's to come
If a big disparity in tax rates between dividends and capital gains again emerges -- and under current law, it would, with maximum capital gains rates rising to only 20% -- then you can certainly expect some companies to move back toward buybacks. I'd argue the best candidates to do so are those with heavy insider ownership that have been leaders in driving special dividends. For instance, Las Vegas Sands (NYSE:LVS) CEO Sheldon Adelson and various relatives and trusts own more than 50% of the company's stock, earning Adelson a $1.2 billion payday from its December special dividend. Sands has raised its dividend and says it's committed to increase it further, but high tax rates could well change Adelson's mind. Spirits-maker Brown-Forman (NYSE:BF-B) and retail giant Wal-Mart (NYSE:WMT) are other examples of companies with big insider ownership that have taken action to accelerate dividends into 2012.
But some newer dividend stocks might be less likely to reverse their recent shifts. For instance, tech giants Apple (NASDAQ:AAPL) and Cisco Systems (NASDAQ:CSCO) just started their payouts very recently, and doing so opened the door to a whole new class of income investors. Neither will want to jeopardize losing those new shareholders, although they may decide not to accelerate payout increases.
Even if tax rates put dividends at a disadvantage, dividends won't entirely disappear in 2013. What may happen, though, is that the trend away from buybacks toward dividends in recent years could reverse itself to save investors some money on their tax bill.