Reality Check on Dividend Taxes

Odds are mighty slim anything like a 43.4% tax will be enacted

   

One of the most contentious parts of the Bush Tax Cuts was the 2003 provision to slash the maximum statutory rate on dividends from 38% to 15%. That controversy still rages today, of course, even though a 2007 Federal Reserve paper argues that the effects of the cuts were modest at best.

“We fail to find much, if any, imprint of the dividend tax cut news on the value of the aggregate stock market,” according to the paper. “Second, there appeared to have been modest but seemingly short-lived cross-sectional effects on stock valuations.”

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Yet, the debate over dividend taxes won’t stop. The top rate on dividends will surge nearly 190% to 43.4%, if the Bush tax cuts are allowed to expire at the end of the year and a separate increase allowed under Obama care kicks in. The effects of such an increase would be devastating, according to the Alliance for Savings & Investment.

“It is clear that older taxpayers earn the lion’s share of dividend and capital gains income and that allowing the current 15 percent tax rate to rise in 2013 will disproportionately hurt older Americans,” according to the group’s website.

A reality check is in order.

Odds are slim that an increase of that magnitude will ever happen during a presidential election year, though rates may rise to a lesser extent, according to Martin Sullivan of Tax Analysts.

Both Democrats and Republicans remain eager to lower the corporate tax rate, “but nobody knows how to pay for it.” Sullivan said in an interview. President Obama, who’s in a tough reelection battle with Republican Mitt Romney, could strike a deal to raise the dividend tax on high earners in exchange for lowering the corporate tax rate, he said.

High-income taxpayers earning more than $200,000 ($250,000 if married) would see their dividend rates reach the top ordinary rate of 36% or 39% under Obama’s proposed budget. Republicans in Congress have vowed to fight any increases, and even the Democrats’ own draft legislation aims for a lower dividend tax figure of 23.8%, according to Bloomberg.

But even if dividend taxes increase, investors shouldn’t hit the panic button because there are other ways to get yield, such as bonds and master limited partnerships.

“It is at best overly simplistic to say that an increase in the taxation of dividends is going to devastate the economy,” Howard Gleckman, a senior research fellow at the Tax Policy Center, said in an interview. “There is no evidence that it’s true.”

Indeed, as Floyd Norris noted earlier this year in the The New York Times, the economy grew at robust pace during the 1950s when dividends taxes were high, while growth was sluggish after 2003 when rates were at their lowest levels ever.

It can also be argued that dividends also have a downside because companies are paying shareholders instead of investing in their businesses by purchasing equipment or buying other companies. The perceived safety of dividend stocks also encourages people to invest in slow-growing companies such as electric utilities, which are among the groups sounding the alarm bell about dividend taxes.

With some form of a dividend tax increase looming, it’s imperative for investors to be selective in chasing yield. As InvestorPlace Editor Jeff Reeves recently noted, high yields are great — provided that they’re sustainable. Consistency paying them out over the long term also is key. Reeves has also just put together a list of “13 Ultimate Dividend Stocks,” which includes the likes of Coca-Cola (NYSE:KO), which has paid its dividend for 50 consecutive years. Unless the world comes to an end, that streak likely will continue.

Follow Jonathan Berr on Twitter @jdberr.

The opinions contained in this column are solely those of the writer.

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