What effect will the change in US tax rates on dividends have on share prices and dividend payouts?
June 3, 2010 5:26 AM Subscribe
What effect will the change in US tax rates on dividends have on share prices and dividend payouts?
In 2011, tax rates on dividends are set to increase after expiration of the Bush tax cuts. Theoretically, what effect will this have on the share prices and dividend payouts of companies who currently pay dividends?
Will companies that currently pay large dividends be incentivized to cut them and invest the money in growth, since the dividends will be of lower value to investors at the higher tax rates? Can investors expect future dividend growth rates to be significantly slower than those over the past decade?
In 2011, tax rates on dividends are set to increase after expiration of the Bush tax cuts. Theoretically, what effect will this have on the share prices and dividend payouts of companies who currently pay dividends?
Will companies that currently pay large dividends be incentivized to cut them and invest the money in growth, since the dividends will be of lower value to investors at the higher tax rates? Can investors expect future dividend growth rates to be significantly slower than those over the past decade?
I would add on a related note that my personal expectation is that there will also be large special dividends in December to get in before the rate change, which will lower stock prices. (Though this is not investing advice; I'm just a layman.)
posted by Admiral Haddock at 6:49 AM on June 3, 2010
posted by Admiral Haddock at 6:49 AM on June 3, 2010
I would expect that dividend payout ratios (dividend / profit) would go down, yes. The effect on share prices will depend on the type of stock, growth stocks (pay less/no dividends, investors make money on capital gains) will become more valuable relative to dividend paying blue-chip stocks (like utilities as JohnnyGunn says) as these have lower growth to harvest cap gains from.
posted by atrazine at 6:59 AM on June 3, 2010
posted by atrazine at 6:59 AM on June 3, 2010
Best answer: One way to value common stock is to use the so-called dividend discount mode, D1 / (k - g), where D1 is the next period's dividend, k is the cost of common equity, and g is the sustainable growth rate of the firm.
k is determined by the Capital Asset Pricing Model (problematic in its own right) and g is the product of Return on Equity and the earnings retention ratio (which equals 1 - dividend payout rate).
OK, given all of that, if D0 = 1 and g = 10%, then we can assume that D1 = 1 * 1.1 = 1.1.
Let's say the cost of common equity is 15%.
Then 1.1 / (0.15 - 0.05) = 11 per share.
Of course, this method of valuing stocks is inherently problematic, in part because so many assumptions are being made about proper values for k and g. See here for a discussion of the shortcomings of the CAPM. g can be fudged because accounting standards allow for manipulation of the numbers that comprise ROE.
So, short answer: the intuition that higher tax rates on dividends will decrease stock prices is incorrect only if (1) we assume that the dividend discount model is the proper stock valuation method, and (2) companies decide to reduce their dividend payouts. The reason the OP's intuition is incorrect, assuming these two assumptions are correct, is that lower dividends tend to mean more cash that the company can reinvest in its business and so grow its business more rapidly.
All this being said, I don't think the dividend discount model is an especially good way to value stocks.
posted by dfriedman at 7:15 AM on June 3, 2010
k is determined by the Capital Asset Pricing Model (problematic in its own right) and g is the product of Return on Equity and the earnings retention ratio (which equals 1 - dividend payout rate).
OK, given all of that, if D0 = 1 and g = 10%, then we can assume that D1 = 1 * 1.1 = 1.1.
Let's say the cost of common equity is 15%.
Then 1.1 / (0.15 - 0.05) = 11 per share.
Of course, this method of valuing stocks is inherently problematic, in part because so many assumptions are being made about proper values for k and g. See here for a discussion of the shortcomings of the CAPM. g can be fudged because accounting standards allow for manipulation of the numbers that comprise ROE.
So, short answer: the intuition that higher tax rates on dividends will decrease stock prices is incorrect only if (1) we assume that the dividend discount model is the proper stock valuation method, and (2) companies decide to reduce their dividend payouts. The reason the OP's intuition is incorrect, assuming these two assumptions are correct, is that lower dividends tend to mean more cash that the company can reinvest in its business and so grow its business more rapidly.
All this being said, I don't think the dividend discount model is an especially good way to value stocks.
posted by dfriedman at 7:15 AM on June 3, 2010
Best answer: Look at Robert Shiller's stock market data here. His Excel file includes S&P 500 data, including price, earnings and dividend going back to the 19th century.
While it certainly makes logical sense that a tax increase on dividends should drive down dividend payouts, there are other factors at play that may be as, or more, important than tax rates. That must be that case since Dividends are already tax disadvantaged relative to stock buybacks, yet companies still pay dividends.
For example...
- Investors like income. Finance academics contend that investors who like income could emulate dividends by selling a portion of their holdings equal to some target dividend payout ratio. This works in theory, but it's a bit complicated to execute in real life.
- Agency problems. The expectation that a company will pay a steady dividend serves to discipline management. It keeps them conservative and focused. Since paying dividends reduces the amount of capital that could otherwise be reinvested into the business, a company that pays dividends is theoretical more likely to have to raise external capital. With external capital comes renewed and intense due diligence conducted by new investors--this is another check on management that helps reduce agency problems.
- Not all investors pay taxes. Stock held by certain institutions and in personal retirement accounts have different tax situations than the typical taxable retail brokerage account. So the tax-driven theories about dividends usually don't apply to the entire shareholder base.
I could go on and on, but that's the gist of the argument for dividends.
posted by mullacc at 7:15 AM on June 3, 2010 [1 favorite]
While it certainly makes logical sense that a tax increase on dividends should drive down dividend payouts, there are other factors at play that may be as, or more, important than tax rates. That must be that case since Dividends are already tax disadvantaged relative to stock buybacks, yet companies still pay dividends.
For example...
- Investors like income. Finance academics contend that investors who like income could emulate dividends by selling a portion of their holdings equal to some target dividend payout ratio. This works in theory, but it's a bit complicated to execute in real life.
- Agency problems. The expectation that a company will pay a steady dividend serves to discipline management. It keeps them conservative and focused. Since paying dividends reduces the amount of capital that could otherwise be reinvested into the business, a company that pays dividends is theoretical more likely to have to raise external capital. With external capital comes renewed and intense due diligence conducted by new investors--this is another check on management that helps reduce agency problems.
- Not all investors pay taxes. Stock held by certain institutions and in personal retirement accounts have different tax situations than the typical taxable retail brokerage account. So the tax-driven theories about dividends usually don't apply to the entire shareholder base.
I could go on and on, but that's the gist of the argument for dividends.
posted by mullacc at 7:15 AM on June 3, 2010 [1 favorite]
I do think it may affect payouts on high dividend stocks, but I don't necessarily think it will affect share prices.
High-div companies like the cigarette makers and telecommunication companies will still be generating a lot of cash. What they do with it may change, though. Perhaps we'll see more stock buybacks or acquisitions, but the underlying value of these companies will stay the same.
In any event, dividends will not go away. They were here long before the tax cuts, and they'll be here long afterwards too.
posted by eas98 at 7:28 AM on June 3, 2010
High-div companies like the cigarette makers and telecommunication companies will still be generating a lot of cash. What they do with it may change, though. Perhaps we'll see more stock buybacks or acquisitions, but the underlying value of these companies will stay the same.
In any event, dividends will not go away. They were here long before the tax cuts, and they'll be here long afterwards too.
posted by eas98 at 7:28 AM on June 3, 2010
Best answer: This journal has an article on the opposite case, whether lowering the tax rate in 2003 increased dividends:
Managerial Response to the May 2003 Dividend Tax Cut
posted by smackfu at 7:32 AM on June 3, 2010
Managerial Response to the May 2003 Dividend Tax Cut
posted by smackfu at 7:32 AM on June 3, 2010
- Not all investors pay taxes. Stock held by certain institutions and in personal retirement accounts have different tax situations than the typical taxable retail brokerage account. So the tax-driven theories about dividends usually don't apply to the entire shareholder base.
This is a really serious point. People who like income tend to hold stocks in retirement accounts. I think it is unlikely there will be a significant change either way. The real world isn't very well described by CAPM.
posted by An algorithmic dog at 1:23 PM on June 3, 2010
Response by poster: Just wanted to say thank you to everyone for all of the thoughtful comments.
posted by underdetermined at 1:46 PM on June 3, 2010
posted by underdetermined at 1:46 PM on June 3, 2010
This thread is closed to new comments.
I think your analysis is on target.
posted by JohnnyGunn at 6:04 AM on June 3, 2010