As dividend tax hike looms, keep faith

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Reuters) - It is never fun to pay more to the government but a potentially massive hike in taxation of dividends next year may not be a reason to bail out of a dividend strategy.

If Congress reaches no agreement the Bush-era 15 percent tax rate for dividends will sail into the sunset December 31, replaced by a top rate of 43.4 percent. Since dividends would then be taxed as regular income, this would comprise a maximum income tax rate of 39.6 percent as well as a 3.8 percent tax on investment income put in place as part of 2009’s health care reform legislation.

To be sure, we can’t know what, if any, compromise will be reached. And doubtless many high-income investors are already front-running the looming changes, though in doing so now they are speculating on politics rather than company fundamentals and cash flows.

There simply isn’t convincing evidence that tax treatment drives the relative performance of dividend shares, or even how company executives manage their use of cash.

Contrast that to the very strong and compelling evidence that dividends drive longer-term investment performance and you have good reason to cross your fingers until January 1 and, if need be, hold your nose and pay your taxes afterwards.

“Dividend strategies appeared to show little correlation with tax rate changes,” strategists at Copeland Capital Management in Conshohocken, PA wrote in a study.

Looking at the period from 1990 to 1993, during which the top rate of dividend taxation rose in two stages from 28 to 39.6 percent, they found that dividend-paying stocks outperformed the S&P 500 over the period, as did a portfolio of high-yielding stocks and another of companies with a track record of increasing dividends. here

Similarly, dividend shares did well in 2002 and 2003, when tax on payouts fell from a maximum of 35 percent to 15 percent. In that period high yielders strongly outperformed, while dividend-growth companies lagged the broader market slightly.

In truth the biggest determinant of returns is probably the rotation of the economic cycle, with dividend shares generally outperforming in all periods except the early take-off stage.

WILL THERE BE DIVIDENDS TO TAX?

It is also possible that corporate chieftains will cut back on dividends in the face of tax rises, perhaps preferring to hold high cash levels or to make new investments or acquisitions. That sort of market distortion is possible, and certainly would be bad news, but the evidence for it is weak.

A 2010 study by the Federal Reserve found little evidence that the 2003 cut in dividend tax drove payouts. While payouts rose, according to the study this was driven by rising profits. here

Copeland looked at more than 50 years of S&P 500 data, covering six different tax regimes, and found no relationship between dividend growth and tax policy. In contrast, the long-term trend is counter-intuitive, as dividend taxation has been in decline along with dividends. While the dividend payout rate was above 60 percent in 1960 it now stands at less than 30 percent.

That decline actually maps very well to the rise in the use of share options as the main driver of executive compensation.

While dividend payouts and growth are great at driving in long-term returns they are not that useful in helping with the kind of two- and three-year target-shooting that most executive contracts require for maximum payout. In many ways, investors would do better to worry about aligning executive interest with their own than fretting about taxation.

That, in the end, is the best argument for tuning out the noise of politics and concentrating on the signal of dividends: they are the single most important determinant of returns.

Research by James Montier of GMO, looking back over U.S. equity data to 1871, found that over a five-year horizon 80 percent of equity returns are driven by dividend yields and by dividend growth. Taken over the very long term, for those of us who have the time, that figure rises to 90 percent.

With interest rates at rock-bottom levels as far as one can see, that is unlikely to change, nor will the aging of the investor base hurt the demand for dividend shares. Hopefully, over time, that changes company behavior and leads to higher payout rates and less short-termism and empire building.

The election will pass, as they do; laws will change, as they do; but dividends will remain paramount.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)