Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. It's very likely that the corporate tax rate will be going up to help fund the spending priorities of the Biden Administration. Joining me today to discuss what a higher corporate tax rate might mean for dividends is David Harrell. David is an editorial director with Morningstar Investment Management, and manager of Morningstar Dividend Investor. Hi, David. Thank you for being here today.
David Harrell: Thanks for having me.
Dziubinski: In a recent issue of Morningstar Dividend Investor, you examined the U.S. corporate tax rates for larger companies that pay dividends over time. What have you found?
Harrell: As you know, corporate tax rates in the U.S. have been on a downward trajectory since the 1950s, when they were up over 50%. Unfortunately, we don't have a good recent example of what happened to dividends following a corporate tax increase. But we do have the example of what happened starting in 2018, after corporate rates came down from 35% to 21%.
Dziubinski: And what happened there?
Harrell: Well, U.S. firms continued to increase their dividends in 2018 and 2019. However, it appears that any dollars that U.S. firms were saving from a lower corporate tax rate were far more likely to be devoted to buybacks or repurchases of their own shares than being funneled to dividends.
Dziubinski: Are the dividend increases that we saw in 2018 and 2019, how do they stack up relative to other periods of dividend increases?
Harrell: They were completely in line with what we saw in the previous six calendar years prior to that tax cut, when the corporate tax rate, the statutory rate, was 35% in the United States.
Dziubinski: So, if a corporate tax rate cut didn't really increase the dividends, can we extrapolate that a corporate tax rate increase won't affect dividends either?
Harrell: There's no way to say for certain. This is like one of those situations where I wish there were parallel universes that we could peer into and see, well, this one had a tax cut, and this one didn't, and what happened with dividend rates. I'm not that worried about dividends, themselves. As you know, Morningstar analysts, when looking at the probability, they have a probability-weighted expectation that U.S. corporate rates are going to rise from 21% to 26%. Now, the worst-case scenario that we're looking at right now with what the Biden Administration has proposed, we drop from 35% to 21% starting in 2018, and they basically want to split the difference and bring the rate back up to 28%. That's the worst-case scenario.
Something to keep in mind though is Morningstar analysts found that, with that 14-percentage-point decrease in the statutory rate, what they actually saw, in terms of effective tax rates for U.S. corporations, taxes fell by about half of that, because not all firms were paying the maximum statutory rate. So I think it's probable that if the tax rate goes up by, say, 5, 6, or even 7 percentage points, what we're more likely to see in the effective tax rate for U.S. firms is an increase 2, 3, 4 percentage points.
And so, what happens there is, of course, all else being equal, if a firm has less cash after taxes, there are fewer dollars to fund the dividend. I think it's unlikely that any firm is going to say we're cutting our dividend because of this. But if you had a firm that had, let's say, a payout ratio of 60%, and the tax increase was going to cause its payout ratio to rise a few percentage points, let's say to 63%, and they want to stay steady at that. What you could see is, perhaps, a moderation in dividend growth going forward, and that wouldn't take much over the course of several years to keep that payout ratio the same.
But I think it's probably more likely that firms, because they were using those extra dollars to funnel money to buybacks as opposed to dividends, I think, if their rate goes back up, it's more likely that perhaps there will be fewer buybacks. And, again, worst-case scenario, we're looking at a corporate tax rate of 28%, which is 7 percentage points below the 35% rate that we had in place from 1993 to 2017. And that was still a period where we saw very healthy growth, at least overall, for dividends for U.S. stocks.
Dziubinski: And then, lastly, of course, there is the possibility that, even if we see a corporate tax increase, it may not be that long-lived, right?
Harrell: That's true. The only reason that the possibility of this is happening right now is you have a Democratic president, House of Representatives, and, by the slimmest of all margins, a Democratic Senate. So we have to consider what's likely to happen over the next couple of election cycles. When it's starting in 2024, well, 2025, after the inauguration, or 2029, if the party control has flipped. You could very well see tax rates, if they have gone up to, say, 26 or 28%, come back down to the 21% they currently are at.
Dziubinski: Well, David, thank you for your time today, and putting the possible corporate tax rate increases into perspective for dividend investors. We appreciate it.
Harrell: Thanks for having me.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.