Latepost The Dividend Taxation Cliff Approaches: Implications For Stocks

Influenza A virus subtype H5N1 dandy bargain has been written most the "fiscal cliff" that the States taxpayers, investors in addition to companies are faced amongst at the terminate of this year. Put simply, all of the revenue enhancement changes made inwards 2002 in addition to 2003 expire at that time, in addition to the revenue enhancement code will, inwards large part, revert to what it was prior to those changes. I volition exit it to others to debate the macro economical implications of going over the cliff but I wishing to focus on i "segment" of the code that has implications to valuation.

In 2003, the revenue enhancement code was altered to select the revenue enhancement charge per unit of measurement on dividend income downward to 15%, to agree the revenue enhancement charge per unit of measurement on uppercase gains. That was, inwards a sense, a revolutionary move, at to the lowest degree for the US, since dividends had been taxed much to a greater extent than heavily than uppercase gains for much of the previous century. I did write a newspaper inwards 2003 most the potential implications of the revenue enhancement constabulary alter for businesses that you lot tin read. In effect, I argued that the revenue enhancement alter would receive got a positive effect on stock prices, that the effect would last greater for "high" dividend paying stocks than for non-dividend paying stocks in addition to that corporate dividend policy would last altered past times the change. Now that at that spot is the possibility that the constabulary volition last reversed, it is fourth dimension to revisit the issue.

Dividends, Expected Returns in addition to Stock Prices: Why taxes matter...

To empathise the impact of investor taxes on dividends, let's start past times looking at how you would cost stocks inwards a solid soil where involvement income, dividend income in addition to uppercase gains are non taxed. Let's assume that the risk costless charge per unit of measurement is 1.5% in addition to that stocks are collectively paying a dividend yield of 2%. To cause you, every bit a risk averse investor, to invest inwards stocks, you lot would ask to last offered a premium (at to the lowest degree on an expected basis) over the risk costless rate. Let's assume that you lot would need a premium of 4.5%, after personal taxes, to shift from the riskfree property to risky equities. Thus, you lot would ask to earn a 6% provide (1.5%+4.5%), later personal taxes, to invest inwards stocks. Since this is a solid soil amongst no taxes, your pre-tax expected provide would likewise past times 6%; amongst a dividend yield of 2%, the expected cost appreciation on stocks would receive got to last 4%.

Now, innovate a uniform revenue enhancement charge per unit of measurement of 15% on involvement income, dividend income in addition to uppercase gains into this world. Since you lot ask to earn 6% later taxes, you lot would ask to earn 7.06% earlier taxes:

Expected pre-tax provide = Expected after-tax return/ (1- Uniform revenue enhancement rate) = 6%/ (1-.15) = 7.06%

Thus, if stocks choke on to pay a 2% dividend, the expected cost appreciation would ask to 5.06%. The higher required provide would hateful that stock prices would receive got to drop, relative to what they were inwards a solid soil amongst no taxes. With the existing revenue enhancement law, nosotros are or in addition to thence this revenue enhancement government (with the alone divergence beingness that involvement income is taxed at a higher revenue enhancement rate). This is or in addition to thence the electrical flow revenue enhancement regime.

Let's right away alter to constabulary to reverberate what the revenue enhancement charge per unit of measurement volition last on Jan 1, 2013, if nosotros practice revert dorsum to pre-2003 levels. The revenue enhancement charge per unit of measurement on dividends, for private investors, volition revert dorsum to the ordinary income revenue enhancement rate. At the margin, for single (married - articulation filing) investors generating to a greater extent than than $ 85,650 ($142,700) in addition to in income, that charge per unit of measurement volition last or in addition to thence 35% (counting exactly Federal taxes in addition to incorporating the additional taxes that the novel wellness attention constabulary volition impose on dividends in addition to other investment income) in addition to approach 40% for those amongst income levels exceeding $178,650 ($217,450). The revenue enhancement charge per unit of measurement on long term uppercase gains volition likewise choke up, but alone to the 20% charge per unit of measurement that prevailed prior to 2003. If companies choke on amongst a dividend yield of 2% in addition to the cost appreciation stays at the 5.06%, investors volition earn a much lower after-tax return:

After-tax provide amongst pre-2003 revenue enhancement rates = 2%(1-.40) + 5.06% (1-.20) = 5.25%

If investors risk preferences receive got non changed, they volition receive got to wishing to choke on to earn 6% later taxes, but the pre-tax provide would receive got to growth to compensate for the higher taxes. In fact, if nosotros assume that the dividend yield stays fixed at 2%, nosotros tin solve for the required cost appreciation

2% (1-.40) + X (1-.20) = 6%

Solving for X, nosotros larn a required pre-tax cost appreciation of 6% in addition to a required pre-tax provide of 8%. That would interpret into a meaning driblet inwards stock prices.

Making it real: The dividend cliff in addition to the S&P 500

To brand this less abstract, let's piece of occupation amongst some existent numbers. At the start of every month, I dorsum out the expected provide on stocks from the grade of the index (S&P 500) in addition to expected cash flows. At the start of September 2012, when the S&P 500 was at 1406.58, I computed an expected provide on stocks of 7.30% (yielding an equity risk premium of 5.75% over the risk costless charge per unit of measurement of 1.55%). This expected provide is what investors are demanding on a pre-tax footing on stocks. Since the electrical flow dividend yield on the S&P 500 is most 2.01%, the expected cost appreciation on a pre-tax footing is 5.29%. Since both dividends in addition to uppercase gains are taxed at 15%, nether the pre-cliff revenue enhancement law, the post service revenue enhancement provide is 6.21%:

After-tax provide inwards September 2012 amongst electrical flow revenue enhancement constabulary = 2.00% (1-.15) + 5.29% (1-.15) = 6.21%

Now, let's assume that investors volition choke on to need this after-tax provide inwards 2013, that the revenue enhancement laws revert dorsum to pre-2003 levels in addition to that companies choke on to hold a dividend yield of 2.01%:

2.01% (1-.40) + Expected pre-tax cost appreciation (1-.20) = 6.21%

The expected pre-tax cost appreciation would receive got to last 6.25% in addition to the required provide on a pre-tax footing would receive got to last 8.26% on the S&P 500, yielding an equity risk premium of 6.71% over the riskfree charge per unit of measurement of 1.55%. Holding the cash flows the same in addition to changing the equity risk premium to 6.71% yields a value of 1201.22 for the S&P 500, a driblet of most 14.60% inwards the index from electrical flow levels. If you lot don't concur amongst the assumptions I receive got made, non a large deal. I receive got attached the spreadsheet that I used in addition to you lot tin compute your ain estimate.

Differential impact: High dividend versus non-dividend paying stocks

Note, though, that the effect of the reversal inwards the revenue enhancement constabulary volition non last uniform, since every companionship does non receive got a dividend yield of 2%. Companies amongst high dividend yields, that choke on to pay those dividends, volition come across expected returns growth to a greater extent than in addition to stock prices driblet past times a to a greater extent than meaning margin. In the graph below, I receive got compute the percent alter inwards stock prices you lot tin await inwards stocks amongst dividend yields of 0% to 4%.

Note that the stocks amongst the 4% dividend yield, belongings all else constant, volition come across stock prices driblet past times 18%,, whereas the stocks amongst the 0% dividend yield volition come across a cost driblet of alone 7%. Again, you lot tin use the spreadsheet and alter my assumptions, if you lot in addition to thence desire, in addition to compute the effect on whatever private stock.

The Weak Links

This analysis suggests that a precipitous correction is ahead for stocks collectively in addition to peculiarly in addition to thence for high dividend paying stocks. It is, however, based on a laid of assumptions most revenue enhancement constabulary in addition to markets that may non last correct. So, what are the weakest links inwards this analysis?
1. There is no risk that the financial cliff volition choke reality: This is non the origin fourth dimension that nosotros receive got faced the possibility of the revenue enhancement laws reverting dorsum to pre-2003 levels. At the terminate of 2011, faced amongst the possibility, Congress in addition to the direction pushed off the hateful solar daytime of reckoning at the final moment. It is possible that faced amongst the catastrophic consequences of going over the cliff, Congress volition honor a agency to avoid it again, but is it guaranteed? Having seen the political dysfunction at both ends of Pennsylvania Avenue over the final decade, I am non every bit confident every bit others may last that mutual feel volition prevail in addition to that the cliff volition last avoided.
2. Not all investors pay taxes on investment income: In my analysis, I used the revenue enhancement rates on wealthy private investors to brand my assessment, but revenue enhancement rates vary widely across investors. There are 2 critiques that tin last mounted. The origin is that most 60-70% of stocks are held past times non-individuals: mutual funds, pension funds in addition to corporations in addition to the revenue enhancement rates that these investors may non last affected (or at to the lowest degree non every bit much) past times the alter inwards the revenue enhancement law. The 2d is that companies that pay high dividends attract investors who similar those high dividends in addition to it is possible that these investors brand less income in addition to confront less of a hitting from the alter inwards the revenue enhancement law. Note, though, that fifty-fifty if nosotros component inwards these investors, the basic analysis silent holds but the impact volition last lightened. In fact, i agency to alter the analysis is to receive got a weighted average revenue enhancement charge per unit of measurement across all investors inwards the market, which would buffer the impact. The graph below estimates the effect on the market, stocks amongst a dividend yield of 4% in addition to stocks amongst a dividend yield of 0% of assuming lower revenue enhancement rates inwards the post-cliff period.

3. Investors may already receive got built inwards the expectation that revenue enhancement laws volition alter into electrical flow stock prices: To the extent that the financial cliff has been inwards the intelligence in addition to widely reported, it is possible that the marketplace has already incorporated the possibility of it coming to fruition into stock prices in addition to the expected return. I would receive got been inclined to believe this if I had seen the equity risk premium climb, in addition to stock prices drop, over the course of didactics of the year, but they receive got not. In fact, nosotros started the twelvemonth amongst a much higher equity risk premium of 6.04% in addition to receive got seen the premium drift downward to 5.75%.

4. Companies may alter their dividend policy: I did predicate my analysis on companies maintaining their dividends at 2012 levels, fifty-fifty if the revenue enhancement constabulary changes to revenue enhancement dividends to a greater extent than highly inwards 2013. In fact, if companies were completely flexible, they could halt paying dividends in addition to largely nullify the impact of the revenue enhancement constabulary change. History suggests that this is unlikely. If at that spot is a give-and-take that best describes dividends, it is that they are "sticky", i.e.. that companies are reluctant to alter dividends in addition to peculiarly to cutting them. In fact, the 2003 constabulary did non to atomic number 82 to a surge inwards dividends (though a few companies pay special dividends inwards the immediate aftermath) in addition to I don't intend that a reversal of the constabulary volition atomic number 82 to a abrupt reassessment of dividend policy.

Bottom line: I may last overly pessimistic, but the dividend cliff scares me in addition to I am planning for the eventuality that the revenue enhancement code volition alter drastically on Jan 1, 2013. I am in addition to volition choke on pruning my portfolio, shifting my coin from large dividend-paying the States stocks to non-dividend paying or low-dividend paying unusual stocks. I won't choke overboard in addition to sell short/ purchase puts on high dividend paying stocks. After all, the dividend revenue enhancement effect is i of many forces that volition impact equity markets over the adjacent few months in addition to it is possible that i of these effects volition drown out the revenue enhancement effect.