Early the morning of November 7th, as he delivered his victory speech to supporters in Chicago, Barack Obama was met with jubilant applause, as he promised “the best is yet to come” for America. By mid-day, however, the party was over: US stock markets declined sharply, with the S&P 500 Index closing the day down over 2%, leaving US investors with a particularly severe hangover after the fifth – worst post-Election Day sell-off in history. The S&P continued its decline Thursday, ending the day down a further 1.25%, for a decline of over 3% across the two trading sessions.
The seeming culprit for the two day market decline is the looming basket of automatic spending cuts and tax rate increases set to kick in on January 2, 2013, collectively known as the “fiscal cliff.” If not acted upon by Congress and the President, these automatic cuts and tax hikes would effectively throw the United States economy into recession from its current path of moderate growth, according to the Congressional Budget Office. While anxiety over spending cuts and income tax hikes is no doubt prevalent, the key focus in coming months for US investors will be the planned escalation of the qualified dividend and long-term capital gains tax rates, which have the potential to dramatically alter behavior among both investors and corporations between now and year end.
Long-term capital gains are investment gains realized on the sale of assets held for one year or longer, and have traditionally been taxed at a preferential rate relative to ordinary income, in part to encourage investment. Since 2003, long-term capital gains have been taxed at a maximum rate of 15% for individuals in the highest federal income tax brackets, and at a minimum of 5% for those in the lowest two tax brackets. On January 2nd, 2013, barring Congressional action, the long-term capital gains tax rate will be raised to 20% for the highest brackets and 10% for the lowest.
Judging by the market reaction Wednesday, institutional investors may have been waiting for the election results to determine how to proceed with their portfolios vis-a-vis the long-term capital gains tax escalation. With Obama re-elected, investors apparently concluded that the tax hike will probably take place, causing them to rush to sell winning stocks before the incremental 5% tax rate kicks in. Not surprisingly, a sampling of prominent year-to-date (YTD) stock winners from 2012 reveals significant underperformance since Obama’s re-election. Shares of companies such as Apple (+33% YTD), LinkedIn (+53% YTD) and Equinix (+71% YTD) all slid more than 6% in the wake of Obama’s re-election, with Apple’s slide alone accounting for more than 40 billion dollars of lost market value.
On the corporate side, the planned escalation of capital gains tax rates could increase shareholder pressure on companies to sell out before capital gains rates can be raised, potentially leading to a “flurry of M&A deals” in the weeks leading up to January 2013. This could serve as a potential windfall to the investment bankers and lawyers advising on these transactions, as the added impetus of a 5 – 10% incremental tax starting January 1st drives companies contemplating sale to pull the trigger before the end of 2012.
While any short-term market pressures resulting from the scheduled capital gains tax hike are likely to be transitory, the scheduled increase of qualified dividend tax rates, also set to take place in January 2013, could have more lasting negative effects. Qualified dividends are cash distributions made by companies to shareholders that meet specific criteria to be treated under the long-term capital gains tax rates. Since 2003, dividends have been taxed at between 0% and 15% for the lowest and highest income tax brackets. However, beginning in January 2013, qualified dividend tax rates are set to skyrocket to 15% and 39.6% for these same tax brackets.
In the current low rate environment (and low qualified dividend tax rate environment), dividend paying stocks have been a rare source of yield for US investors, with risk / reward profiles generally superior to interest yielding debt. As a result, dividend income has risen in recent years to about 7% of disposable income for the average American, versus interest income from bonds at 9% of disposable income. The 2% spread between dividend and interest income as a percent of total income is the smallest spread in history, with the peak difference occurring in the mid-1980s, when dividend income accounted for roughly 3% of disposable income versus interest income at over 18%. Thus, due to heavy investor reliance on dividend stocks, a disruption to the dividend tax rate now would detract more from investment income than at any point before in history and generate instability in the financial markets.
Furthermore, dividend stocks tend to be held in the highest concentration by conservative and income oriented investors such as retirees. With the current S&P 500 dividend yield standing at 2.15% and the S&P 500 up nearly 22% since January 2010, dividend stocks have been a major contributor to conservative investor portfolios, and in cases where the new January 2013 statutory tax rates are applied the net after-tax dividend realized by these investors will be reduced by 15 – 30%.
On the corporate side, taxing dividends at a higher rate may make companies less likely to pay dividends, since dividends’ effective value are reduced by a higher tax rate. Some may opt to return cash to shareholders in other ways (such as via stock buybacks), however some companies may prioritize acquisitions in lieu of dividends, or simply hoard more cash. To the extent corporations are able to re-allocate dividend payments towards profitable, high return on capital investments, the net effect on the economy could be neutral to positive. However if companies hoard cash or make ill-advised acquisitions instead, the impact would likely be detrimental to the economy and to market returns. Finally, some companies may elect to pay so called “special dividends,” akin to one time cash windfalls paid in advance of the tax rates going up in 2013.
As we have already seen in the wake of Obama’s re-election, the foreseeable result of uncertainty surrounding the planned escalation of US qualified dividend and capital gains tax rates in 2013 will be to place the market under intense short term pressure as investors seek to lock in gains at the lower capital gains tax rate and revisit their portfolio allocations, potentially casting dividend stocks out in favor of other investments, with or without yield. Companies may be pressured by their largest investors to sell in advance of the capital gains tax increase. The longer the uncertainty drags on, the more chaotic the next several weeks could become.
The right, and optimal, path for the President and Congress to follow is to quickly and decisively establish what the tax rates will be for qualified dividends and capital gains in 2013 and going forward. This will allow investors to make informed decisions about their portfolios rather than blind guesses, and should help to comfort markets and prevent emotional selling of stocks with gains. Corporations would also benefit from this clarity, and would not have to consider accelerating strategic moves such as M&A due to the mere possibility of a rate increase.
Also, in the case of the proposed rate increase on qualified dividends, Congress may want to seriously reconsider such a dramatic increase in taxation. The effective 15 – 30% rate increase on qualified dividends would reduce income to yield starved retirees in a low rate environment where few alternative investments are attractive. The higher tax rate could cause a flood of capital out of traditionally conservative investments with yield (while there are exceptions, many dividend paying companies are “blue – chip” stocks with a lower risk profile than non – dividend payers) and into alternative investments such as small cap growth stocks with higher risk profiles, increasing market volatility and potentially misallocating capital. During the last period when dividends were taxed at a higher rate than capital gains, investors flocked to speculative technology stocks in the so called “dot com bubble” of 1998 – 2000, which obviously ended badly for investors and the economy as a whole.
Finally, a hypothetical tax rate of nearly 40% on qualified dividends seems onerous, in light of the fact that this is essentially a “second tax” on a company’s earnings (corporate earnings are taxed, and then dividends are paid from those earnings and taxed again). Increasing dividend taxes would be a disruptive and unfair way to raise government revenue, and would likely have adverse economic consequences.
US investors and corporations deserve transparent, fair and immediate tax policy guidance from Congress and the Obama administration, which will hopefully be issued in the coming weeks.
