Examining The Dividend Tipping Point

Tax law changes make dividend-paying stocks the choice for the future.

By Don Schreiber Jr.

As people begin to understand the administration’s new tax policy, we’re going to see a dynamic shift in investment philosophy—not just by professional advisors, but also by individual investors and corporate leaders.

The last dynamic change in tax policy was created under the 1981 Economic Tax Recovery Act, which created a tax preference for capital gains. At the time it seemed impossible that people would ever invest in stocks again. So in order to get the economy moving and to allow companies to compete, the tax on capital gains was lowered.

The government did not hand investors a capital gains windfall out of the kindness of its heart. The strategy was to draw investors back into the stock market. What happened? Only the longest economic expansion in history. The Dow soared from 777 to 11,600—a stunning 15-fold increase in value.

If the capital gains tax preference could bring investors back to the market after one of the worst long-term performance cycles on record, then what is the dividend tax preference likely to do today? Human nature tells us investors will rush to take advantage of the tax benefits being offered.

This new tax bill may have signaled the next bull market. But, in order to catch this wave, you are going to have to throw out what worked in the past and focus on what will work in the future: namely, buying stocks that pay dividends.

Changes In Tax Policy

Four basic changes to the tax law are a boon to your clients:

1. Federal income tax rates were reduced on ordinary income. The top federal tax bracket was reduced from 38.6% to 35%, reducing the amount of tax investors will have to pay on interest from savings accounts, money markets, certificates of deposit and bonds.

2. Federal income tax brackets were expanded, increasing the amount of income an individual could have and still qualify for a lower bracket. For example: In 2002, a married couple filing a joint return would move to a tax bracket higher than 15% when their taxable income exceeded $47,450. Under the new law, the same couple will be able to book taxable income up to $56,800 and still pay tax the 15% rate. This expanded bracket will allow more investors to take maximum advantage of the lowered capital gains and dividend rates.

3. Long-term capital gains tax rates were reduced from 20% to 15% for investors with taxable income that would place them in a tax bracket higher than 15%. Long-term capital gains rates were reduced from 10% to 5% for investors with taxable income that would place them in a tax bracket at or below 15%. Because of the expansion of tax brackets, many people who were paying 20% tax on capital gains will find their new tax rate reduced by 75%, to 5%. The new capital gains brackets apply to sales taking place after May 6, 2003.

4. Dividend tax rates were also reduced and will now be taxed on “Schedule D” of the income tax return, like capital gains. Beginning with the 2003 tax year, dividend income that had previously been added to all other ordinary income, ballooning taxable income, will no longer be included in the ordinary income calculation. ,This will allow many investors to fit into a much lower tax bracket on all other ordinary income, but the major change is that dividends will be taxed at capital gains rates. Dividend tax rates were reduced from ordinary income tax rates, which had been upwards of 38.6% for high-income investors. These same high-income investors will now only pay 15%—a 61% reduction in tax. Investors with taxable income that would place them in the 15% bracket or lower will now pay only a 5% tax on their dividend income. That’s right—just 5%. And because of the expansion of tax brackets, many more middle-income investors will enjoy a dividend windfall paying 75% to 85% less tax on their dividends. Eureka!

Likely Effects On Markets

At some point, these tax reductions will likely set off a buying spree by American investors that will stimulate the economy into a new expansion phase and will set the tone for a broad-based market recovery.

It is obvious that the new tax law has been engineered to stimulate the consumer to spend by cutting taxes, which puts more money in their pockets. And since consumer spending accounts for more than 65% of U.S. economic activity, increased consumer spending will also provide a needed boost to corporate revenues and stimulate economic growth.

This foundation of expanding economic activity and higher corporate revenue should significantly increase profits, and we know that increased profits usually translate into higher stock prices. If we will look back 20 years, we see that dynamic changes to the tax law that provided major tax incentives were the key to charting the course for economic recovery and prosperity. We have historical evidence that the 1981 tax act provided the basis for the longest economic expansion on record, and one of the greatest bull markets of all time. It would seem likely that the 2003 tax act will not only provide economic stimulus, but also build the foundation for the beginning of a new bull market. But most important of all, it will dramatically change the way people invest.

Changes In The Way You Invest

Most investors are very motivated by tax issues when making decisions about investing their hard-earned money. They know that the more they pay to the taxman, the less they get to spend or to keep reinvesting to fund goals. Again, if we let history be our guide, we can clearly see that investors will change the way they are investing to keep their tax burden to a minimum.

The 1981 tax incentive proved so powerful that not only did investors change the way they invested, but it also changed corporate policy decisions on how companies might best attract investors to their stocks. In 1979, 77% of the corporations that made up the S&P 500 routinely paid out 55% of their earnings in dividends to investors. With the advent of preferential tax rates on long-term capital gains, investors shifted their focus from stocks that paid dividends to stocks that reinvested their profits to drive growth. Corporate policy followed this trend and reduced or completely eliminated dividends and concentrated on attracting these new capital-gains-focused investors. That game is over.

Investor focus will change due to the huge tax reductions on dividends—and corporate policy will follow. The obvious winners will be those stocks that qualify for the new dividend tax preference and, to a lesser extent, those assets that qualify for reduced capital gains tax treatment. However, not all stocks qualify for the new dividend tax. For example, some stocks that already have some tax preferences built in—like real estate investment trust (REITs) and master limited partnerships (MLPs)—do not qualify for lower tax rates on their dividends. It is also pretty obvious that investments that generate interest income—government and corporate bonds, savings accounts, certificate of deposits and money markets—will be big losers, because the income they generate will be taxed at the much higher “ordinary income” tax rates. Even tax-free bonds may suffer, because the new lower tax rates on dividends make their tax-free yields less competitive.

Bonds will be the big loser. The problem with bonds goes well beyond their tax inefficiency under the new law. Investors purchase bonds for their coupon or fixed-income stream, which is payable over the life of the bond. Because this income stream is fixed at initial purchase and never changes, it fails to keep pace with inflation.

Inflation increases the cost of living for investors, but the bond income stream does not increase to help them keep pace with these rising costs. In addition, the initial investment made to purchase the bond also fails the inflation test because it never increases in value. If inflation averages just 4% per year, the initial investment of $10,000 is only worth $4,604 twenty years later. The original bond investment has declined 54% in purchasing power when it is returned at maturity year. And last but not least, the interest income from a bond is included in taxable income, possibly shifting you into a higher tax bracket where you will pay 40% to 85% more on each dollar of income.

Other interest-generating investments like money markets, CDs and savings accounts have the same disadvantages outlined above for bonds. While investors often shy away from stocks because of volatile price changes, they don’t seem to realize how volatile bond prices can be. In a rising-interest-rate environment, bond prices fall as new bond interest rates exceed those of bonds already issued, making them more attractive to investors. With interest rates already at 50-year lows, investors need to watch out for rising interest rates or they may once again notice frightening declines in the value on their accounts.

Unexpected Reversals

This new emphasis on dividends fits in the aftermath of Enron, World Com, Global Crossing and Arthur Andersen, because you can’t fake dividends. Companies have to have cash to pay dividends. They can’t jury-rig dividend payouts, like they did their financial statements to show phantom profits. Companies that previously chose to forego dividend payments on their stocks because of the 1981 tax act will reverse direction and reinstate their dividend program. And companies that are paying dividends now will increase dividend payouts to make their stocks even more attractive.

As in the past, this shift in tax policy is going to have a huge impact on the way companies attract investors, and the name of the game will be to attract investors by paying more dividends than ever before. Companies that don’t pay dividends today will initiate dividend payout plans; and companies that are already paying dividends will increase their dividend payouts to attract new investors like never before.

People are going to start buying investments based not only on the dividends they receive, but also on how much tax they are going to pay. Bond investors will make a “polar shift” in their investment allocations.

This new tax policy will create a winning situation: first, by providing a level playing field with the capital gains tax; and second, when companies pay out higher dividends, they will be able to fund growth by issuing equity rather than debt. This will create a virtual cycle, making stocks more attractive to investors—which in turn creates more demand—which should fuel higher stock prices.

Don Schreiber, Jr., author of Building a World Class Financial Services Business: How to Transform Your Sales Practice into a Company Worth Millions, is president and CEO of Wealth Builders Inc., a wealth and money management firm headquartered in Little Silver, N.J.