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If the Bush Tax Cuts expire, will it hurt the share price of a company that pays a large, regular dividend? In another edition of the Treasurer's Inbox, a treasurer explains to a CFO why there's no need to worry.
Patrick Guido, CFO.com | US
August 31, 2012
Although the subject matter below is based on real-world experience, all characters, figures, and settings are fictitious and are not based on the financial situation or strategy of any specific company.
From: CFO, Large Cap U.S. Company with a High Dividend Payout
Subject: If dividend taxes increase, will our stock be negatively impacted?
Subject: Re: If dividend taxes increase, will our stock be negatively impacted?
The clock is indeed ticking on the Bush Tax Cuts, which are set to expire at the end of the year unless by some miracle our divided Congress can work together to pass an extension. Should tax increases go into effect, not only would dividend tax rates be subject to a maximum rate of 43.4% (maximum individual bracket plus 3.8% health-care tax) but also capital-gains taxes would increase to 23.8%. The huge increase in the dividend rate, coupled with the gap that would be created between capital gains (both are equal today at 15%), could result in a flight from dividend-paying stocks.
We have taken the time to research this issue and I am happy to say that our stock will not be the slightest bit affected by tax rates. Here is why:
Dividends are critical to returns. A look at total equity returns for the S&P 500 over the past several decades reveals that dividends have accounted for nearly half of total returns. In fact, during down markets in the 1930s, 1970s, and most recently, dividends have actually salvaged what otherwise would have been flat or negative returns. Why would any savvy investor turn his back on dividends, especially in this volatile market?
Dividend-paying stocks remain in high demand. Dividend-paying stocks like ours remain in vogue within the investing community. First, dividend stocks have performed exceptionally well during the past few years. The S&P High Yield Dividend Aristocrats Index is up 17% and 34% on a one- and three-year basis, respectively. Second, dividend yields have actually surpassed bond yields in some instances. So investors can have all the upside of owning a good company at an attractive valuation, with the safety of current income similar to that of a bond. Lastly, an aging population relies on dividends. With baby boomers retiring and the population of people over age 65 expected to double in the United States in the next 20 years, there will be a high demand for securities that generate current income.
Institutional investors will not be directly affected.Even though corporate insiders and retail investors will be greatly affected by a higher dividend tax, it is important to recognize that more than 75% of our shareholder base consists of institutional investors. This includes pension funds and 401(k) plans, which defer taxes. It also includes institutions that are evaluated on pretax performance (e.g., hedge funds and money managers) or have exemptions from dividend taxation (e.g., nonprofits and corporations).
There is no evidence yet of companies adjusting shareholder payouts based on taxation. If companies that pay dividends are planning to find a more tax-efficient way to return cash to shareholders, they have a funny way of signaling it. In the past two years, the number of companies initiating or increasing regular dividends has doubled. Moreover, an analysis of dividend-payout ratios over a longer period shows that payouts have actually been falling consistently, not fluctuating as tax treatment changed. In fact, when the Bush Tax Cuts were enacted back in 2003 and dividend tax rates were lowered, companies did not react by increasing dividend payouts.
In summary, there is certainly no reason to take any action until the Presidential election, when we will have more certainty regarding tax increases. Should Congress continue to flounder and fail in extending tax cuts, I still don't think there is anything we need to do. If anything, we should increase our dividend to send a bullish signal to the markets about our performance. Dividends have been popular with many investor segments for more than three-quarters of a century, through a host of different tax regimes; they will be even more popular going forward.
Patrick Guido is vice president and treasurer of publicly held VF Corp., a $10 billion global apparel and footwear company with brands that include The North Face, Vans, and Timberland. Patrick has more than 17 years of experience in corporate finance. He earned an undergraduate degree from Georgetown University and an MBA from Vanderbilt University.