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By Jeremy Glaser and Josh Peters, CFA | 07-23-2012 11:00 AM

Dividends' Appeal Will Endure

Policymakers will likely keep tax rates low, but even if current rates expire, dividend payers would still offer a superior source of income, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Tax considerations are often top-of-mind, particularly now with so much fluidity in the tax system and the upcoming changes or potential changes at the end of this year. I'm here today with Josh Peters, editor of Morningstar DividendInvestor, to get an update on what's happening with tax laws and how it could impact dividend payers.

Josh, thanks for joining me.

Josh Peters: Good to be here even if it's my least favorite topic.

Glaser: I know we've talked about this before, but can you just give us a quick update on what's happening with tax rates? What the current law is? What could happen in 2013? What do you think is likely to happen in terms of changes Congress could make?

Peters: Well, right now nothing is really changing. They really don't have a will or a way in Washington to pass any serious legislative reforms right now. I think we're going to have to get through the election and have to have that verdict from the American people before we'll see the two parties in Washington actually start to come together, make some compromises, cooperate a little bit, and start to solve some of these problems.

Now, under the current law as opposed to the current policy, we're looking at significant tax increases. You can call them the expiration of tax cuts, but for anybody who is been paying taxes at lower rates, which is almost all of us over the last five to 10 years, it's going to feel like, smell like, and hurt like a tax increase. And I think that most of economists are correct in saying that this is going to have a negative impact on the economy and could even tip us back into recession.

Now, realistically, are we going to just fall off that fiscal cliff, are we going to see all of the spending cuts and all of the tax cuts expire here at the end of the year? I don't really think that's realistic. After the election, there'll be some settling of the dust. Nobody wants us to actually tip back into the recession if it's something that we can prevent through actual legislation. So, the question becomes what do we get? My guess is, we'll see either the vast majority of the tax cuts or perhaps all of them extended, maybe not for two years this time, as we did in 2008 and 2010. Maybe it’s only a year. Some people have floated the idea of only three months. They continue to hold Washington's feet to the fire about enacting really comprehensive tax reform, but I just don't think that it's at all realistic that we're going to see tax rates all of the sudden shoot up.

Within that whole package of tax cuts, the current tax treatment of dividends is pretty important. Having leveled the playing field between long-term capital gains and dividends back in 2003, I think really corrected a historic inequity. There is no reason why the tax code should favor capital gains over dividends. They both come from the same source, corporate earnings, which themselves have already been taxed at the corporate level. I think even Congress, even in Washington, they understand this now, especially given the demographic background, knowing that more and more people are going to be looking to and relying on dividends in retirement. I really don't think that once we get to a reform stage that we're going to go back to effectively the bad old days when dividends really were taxed at penalizing rates.

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