Jeremy Glaser: The future of dividends and taxation. I'm Jeremy Glaser with Morningstar.com. I'm joined today by Josh Peters, editor of Morningstar Dividend Investor, to talk about what Congress and the administration is thinking about in terms of dividend tax rates in the future. Josh, thanks for talking with me today.
Josh Peters: Happy to be here. Wish it was a more happy subject. [laughs]
Glaser: [laughs] Well, as the Bush tax cuts are scheduled to expire, there could be some major changes to dividend tax rates. Could you talk a little bit about the history of dividend taxes?
Peters: Yeah, I think it's important to remember that dividend investing, and the appeal of dividend investing - getting that steady stream of cash that's coming directly out of the profits of the companies, that you own a share of, are earning - that's been around a long time. Even when tax rates were 93 percent in this country, companies still were paying dividends, because that is essentially what companies are paid to do, or are organized to do, on behalf of their investors.
And you go back all the way to the creation of the federal income tax, dividends were typically taxed as ordinary income, which in some cases would be very high top marginal rates for the highest earners, while capital gains were taxed at lower rates. Then, 2003, finally we had dividends and capital gains, which really both come from the same ultimate source, which is corporate profitability, put on an equal footing with a maximum tax rate of 15 percent.
That's been the status quo since 2003, but these tax cuts, like a lot of other tax cuts in that piece of legislation, will automatically expire at the end of 2010. If Congress does nothing, if there is no change to the actual tax code, then next year long-term capital gains taxes would rise to potentially a top bracket of 19.8 percent, while the taxes on dividend income could go as high as 39.6 percent. That was the old top marginal tax rate before the '03 Act.
Glaser: What are some of the proposals out there now for changing the legislation or changing the tax code?
Peters: I kind of look at there being two main options, although it's even kind of hard to characterize them as proposals or specific legislation. I mean, it's very murky, and this issue has really been on the back burner of a lot of people's thinking in Washington. There's so many other more pressing problems that would seem that the government has to attend to.
But the first is, what the president has proposed, and in fact proposed it back in his campaign days, which was to create another 20 percent tax bracket - that would apply to both qualified dividends and long-term capital gains - for higher earning households, married, filing jointly, above $250,000 a year. That would be a tax increase. I'm not going to characterize it as pleasant. But it is a more moderate approach, as opposed to going back to the old tax rates.
The only piece of legislation, that has actually started to move in Congress, which is the senate budget for next year, has actually proposed to keep the existing tax rates capped at 15 percent for households under that $250,000 mark. But, after that point, the old tax rates, the top 39.6 percent, would come back. And even worse I think, than the tax rates being increased on both dividend income and long-term capital gains, is that you'd go back to that penalty rate essentially on dividend income.
That long-term capital gains are somehow being deemed as better indirectly by the government, while dividends are paid, pay taxes at a much higher rate. I think that has a lot of drawbacks, and that companies perhaps don't think real clearly about capital allocation when they start looking at the way the taxes line up.Read Full Transcript
Glaser: What could some impacts be then, if we start taxing dividends and capital gains at vastly different rates?
Peters: Well, you might see that companies decide that they want to pay out more of their cash flow in the form of share repurchases. Share repurchases, which if they are made at a gain from whoever is selling their shares back to the company, then become capital gains income. I think share repurchases, in most ways, don't work, or they don't work very well. Most companies tend to buy their shares back when the price is high, when earnings are very good, there's lots of cash laying around.
They're buying high, and then perhaps they get into trouble later on. They're selling those same shares back to raise more money to try to deal with debts, and they're selling low. They're actually destroying a lot of shareholder value as they go along. You pay a dividend, never hurt anybody. At the very worst, it's value-neutral. The shareholder gets to keep whatever cash he or she has received.
Also, I think that there is a chance that investors might let this mess with their thinking. That rather than getting that steady stream of income, that is coming directly from the company and really proves the cash value of that investment in a business, they're going to think, well, if the tax code favors capital gains, now I've got to start trading. I've got to start thinking for big doubles and triples in the stock price, as opposed to looking for a steady dividend payer that might in fact serve their purposes better.
It's important to remember that really nobody is talking about using dividend taxes on everyone. It would be upper income earners, in all likelihood, only. And it wouldn't apply to 401Ks and IRAs. It wouldn't apply to REIT dividends, which have always been taxed at ordinary income, or MLP distributions. You're looking at a relatively small group of effects, but I think that there is a potential for overreaction, that could make the effect a lot larger, as it might play out in the way people think about it than it really needs to be.
Glaser: So investors don't need to necessarily make any wholesale changes to their stock, or dividend, stock picking activities, just because this tax legislation is working its way through, or could work its way through?
Peters: Yeah, we're actually a long way away from actually seeing a change to the tax law, because even if this proposal, that came out of the Senate Budget Committee, remains part of the final budget, that still doesn't change the tax law. You still have to have an actual bill, that would come from the House Ways and Means Committee originally, be passed and signed into law, to change the tax code.
I think that this is an issue that is worth watching as the year unfolds. And I think that we're going to see some kind of action on it before the end of the year, probably before election day. We've got mid-terms coming up in November. But I think that it's important to keep perspective.
Just to use this as an example, I looked back - and my most recent issue of DividendInvestor talked about this in my cover story - say, well, did dividend payers really do well after tax rates were cut? And in fact, using our Morningstar Dividend Leaders Index, of high-yielding stocks as a proxy relative to the S&P 500, kind of the whole market, the performance, the total returns, were almost identical for the first three years after the tax cut was passed. So it wasn't as if changing the tax rates suddenly made these stocks hugely outperform. The dividends did not come into existence as an appealing investment strategy, just when the tax laws were changed in 2003.
If the tax laws become less favorable toward dividend income, it's going to affect some people. It might even affect some people's individual portfolio decisions. But I think that this is a wait, and watch, and guard against overreaction, type of situation, as opposed to something that you want to just throw up your hands and say I'm done with dividends. That's not what you want to do.
Glaser: All right. Thanks, Josh.
Glaser: For Morningstar.com, I'm Jeremy Glaser.