The deal that emerged this New Year’s Eve was much better for the markets and dividend-paying stocks, as Obama preserved the preferential tax rate on dividends for many investors. I believe it is a good practice to keep the tax rate on dividends and capital gains equal, so as to not encourage companies to favor stock buybacks over dividends.6 There has been a trend over the last 30 years for companies to reduce their dividend payout ratios , which I attribute to the heavy compensation of executives with stock options (which benefit more from buybacks than dividends).
Truthfully, I believe there is more we should do with respect to dividend tax policy to improve the attraction of our capital markets. I believe dividends should be tax deductible to corporations just like interest payments on corporate debt. Currently our tax policy incentivizes firms to issue debt financing, as firms can deduct interest payments and pay lower taxes as a result of this debt service. When firms issue equity to finance their activities, they must pay dividends out of after-tax income. This double standard encourages companies to issue more debt and less equity and this higher debt financing makes our equity markets riskier7, in my opinion.
Obama has stated that he would like to review our corporate tax rates, which are among the highest in the world. A great way to update corporate tax policy would be to make dividends tax deductible just like interest payments. This would make our capital markets more enticing and help to lower the net tax rate of companies. Retirees who invest for dividend income would benefit from companies paying out more of their cash as dividends, especially when other sources of income are so scarce. This would also add additional corporate governance benefits as firms returned cash to their shareholders who could then decide how they wanted to deploy it.
Despite this view of the best dividend tax policy, I am very pleased our politicians came together on New Year’s Eve to avert a full fall off the Fiscal Cliff.
There is much work still to do to get budget deficits and spending in line with the revenues collected. But I believe that the markets will like this deal. I believe that dividend investors will like this deal. We can now turn our attention to the debt ceiling discussion, which is when the next set of serious decisions will be made with respect to fiscal spending.
Jeremy Schwartz is director of research at WisdomTree Investments (NasdaqGM: WETF). This post was republished with permission from the WisdomTree blog.
1“United States Avoids Calamity in ‘Fiscal Cliff’ Drama.” Reuters. January 2, 2013.
2“Here’s What the Senate’s ‘Fiscal Cliff’ Deal Looks Like.” Reuters. January 1, 2013.
3“Here’s What the Senate’s ‘Fiscal Cliff’ Deal Looks Like.” Reuters. January 1, 2013.
4Individual Income Tax Returns 2010: Publication 1304. Internal Revenue Service. 2012.
5Internal Revenue Service, 2012.
6Source: Professor Robert Shiller, Yale University, 2012. Dividend payout ratios indicate the ratio of earnings per share divided by dividends per share. Higher numbers indicate that a firm’s level of earnings can better cover its dividend payments.
7Debt financing can potentially increase a firm’s level of risk because holders of a firm’s debt must continue to be paid regardless of the firm’s business prospects or market environment.