The "dividend tax" cliff approaches: Implications for stocks

September 30th, 2012
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A great deal has been written about the "fiscal cliff" that US taxpayers, investors and companies are faced with at the end of this year. Put simply, all of the tax changes made in 2002 and 2003 expire at that time, and the tax code will, in large part, revert to what it was prior to those changes. I will leave it to others to debate the macro economic implications of going over the cliff but I want to focus on one "segment" of the code that has implications to valuation.

In 2003, the tax code was altered to bring the tax rate on dividend income down to 15%, to match the tax rate on capital gains. That was, in a sense, a revolutionary move, at least for the US, since dividends had been taxed much more heavily than capital gains for much of the previous century. I did write a paper in 2003 about the potential implications of the tax law change for businesses that you can read. In effect, I argued that the tax change would have a positive effect on stock prices, that the effect would be greater for "high" dividend paying stocks than for non-dividend paying stocks and that corporate dividend policy would be altered by the change. Now that there is the possibility that the law will be reversed, it is time to revisit the issue.

Dividends, Expected Returns and Stock Prices: Why taxes matter...
To understand the impact of investor taxes on dividends, let's begin by looking at how you would price stocks in a world where interest income, dividend income and capital gains are not taxed. Let's assume that the risk free rate is 1.5% and that stocks are collectively paying a dividend yield of 2%. To induce you, as a risk averse investor, to invest in stocks, you would need to be offered a premium (at least on an expected basis) over the risk free rate. Let's assume that you would demand a premium of 4.5%, after personal taxes, to shift from the riskfree asset to risky equities. Thus, you would need to earn a 6% return (1.5%+4.5%), after personal taxes, to invest in stocks. Since this is a world with no taxes, your pre-tax expected return would also by 6%; with a dividend yield of 2%, the expected price appreciation on stocks would have to be 4%.

Now, introduce a uniform tax rate of 15% on interest income, dividend income and capital gains into this world. Since you need to earn 6% after taxes, you would need to earn 7.06% before taxes:
Expected pre-tax return = Expected after-tax return/ (1- Uniform tax rate) = 6%/ (1-.15) = 7.06%
Thus, if stocks continue to pay a 2% dividend, the expected price appreciation would need to 5.06%. The higher required return would mean that stock prices would have to drop, relative to what they were in a world with no taxes. With the existing tax law, we are close to this tax regime (with the only difference being that interest income is taxed at a higher tax rate). This is close to the current tax regime.

Let's now change to law to reflect what the tax rate will be on January 1, 2013, if we do revert back to pre-2003 levels. The tax rate on dividends, for individual investors, will revert back to the ordinary income tax rate. At the margin, for unmarried (married - joint filing) investors generating more than $ 85,650 ($142,700) and in income, that rate will be close to 35% (counting just Federal taxes and incorporating the additional taxes that the new health care law will impose on dividends and other investment income) and approach 40% for those with income levels exceeding $178,650 ($217,450). The tax rate on long term capital gains will also go up, but only to the 20% rate that prevailed prior to 2003. If companies continue with a dividend yield of 2% and the price appreciation stays at the 5.06%, investors will earn a much lower after-tax return:
After-tax return with pre-2003 tax rates = 2%(1-.40) + 5.06% (1-.20) = 5.25%
If investors risk preferences have not changed, they will have to want to continue to earn 6% after taxes, but the pre-tax return would have to increase to compensate for the higher taxes. In fact, if we assume that the dividend yield stays fixed at 2%, we can solve for the required price appreciation
2% (1-.40) + X (1-.20) = 6%
Solving for X, we get a required pre-tax price appreciation of 6% and a required pre-tax return of 8%. That would translate into a significant drop in stock prices.

Making it real: The dividend cliff and the S&P 500
To make this less abstract, let's work with some real numbers. At the start of every month, I back out the expected return on stocks from the level of the index (S&P 500) and expected cash flows. At the start of September 2012, when the S&P 500 was at 1406.58, I computed an expected return on stocks of 7.30% (yielding an equity risk premium of 5.75% over the risk free rate of 1.55%). This expected return is what investors are demanding on a pre-tax basis on stocks. Since the current dividend yield on the S&P 500 is about 2.01%, the expected price appreciation on a pre-tax basis is 5.29%. Since both dividends and capital gains are taxed at 15%, under the pre-cliff tax law, the post tax return is 6.21%:
After-tax return in September 2012 with current tax law = 2.00% (1-.15) + 5.29% (1-.15) = 6.21%
Now, let's assume that investors will continue to demand this after-tax return in 2013, that the tax laws revert back to pre-2003 levels and that companies continue to maintain a dividend yield of 2.01%:
2.01% (1-.40) + Expected pre-tax price appreciation (1-.20) = 6.21%
The expected pre-tax price appreciation would have to be 6.25% and the required return on a pre-tax basis would have to be 8.26% on the S&P 500, yielding an equity risk premium of 6.71% over the riskfree rate of 1.55%. Holding the cash flows the same and changing the equity risk premium to 6.71% yields a value of 1201.22 for the S&P 500, a drop of about 14.60% in the index from current levels. If you don't agree with the assumptions I have made, not a big deal.

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