Many American politicians make it clear that they are only raising the dividend tax rate for those who earn more than a million dollars a year. This assertion sounds populist, but the rhetoric masks the risks of hurting ordinary Americans, encouraging short-termism, and expanding corporate power.
Such a tax increase will result in a reduction in corporate dividends. (Note that the reverse is also true – when taxes on dividends go down, corporations increase dividends.) The decision to reduce dividends is ultimately a decision for every company. Boards of directors set dividends by judging whether it is the company or its shareholders who can deploy every dollar of profit more effectively. If shareholders pay higher taxes on dividends, each of those dollars is less useful to them, and boards of directors will instead keep more of the profits to deploy in some other way.
Therefore, anyone who receives dividends will be adversely affected by an increase in dividend tax, even if they do not pay it directly. Some 27 million Americans report dividend income on their tax returns, with more than half having a total annual income of less than $ 100,000 and another quarter earning between $ 100,000 and $ 200,000.
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Middle-class investors rely on dividends to supplement household budgets or to build up retirement funds. Dividend cuts resulting from increased dividend taxes will take money out of their pockets. The hardest hit would be older Americans, as those over 55 make up the majority of dividend-paying tax returns, receiving the lion’s share of all dividends paid, according to IRS data.
Higher taxes on dividends also discourage longer-term prospects. Larger and more regular dividends give shareholders a reason to stick around during tough times. As famed mutual fund manager Peter Lynch argued, these dividends are a magnet that lengthens holding periods. Lower dividend levels therefore mean shorter time horizons.
In fact, many Americans have long held a substantial portion of their nest egg in some of the nation’s most respected companies, precisely because of their generous dividend policies. For example, investors praise the elite group of 65 companies that have posted increases in their annual dividends for at least 50 consecutive years – they are called the dividend aristocrats.
A few examples, all of which are at the top of the list to attract the most focused and long-term American shareholders (quality shareholders): Coca-Cola, Dover, Genuine Parts, Hormel Foods, Johnson & Johnson and Procter & Gamble. Even sustaining steady increases in dividends for a decade is difficult, with fewer than 300 companies achieving this feat. With the increase in dividend taxes, expect this revered group to shrink even further.
At the other end of the spectrum are companies that have never paid dividends, or in recent memory. The reasons are mixed, ranging from meteoric growth opportunities to difficulties in meeting bills. With higher dividend taxes pushing boards to cut dividends, expect this cohort to grow in size. If so, it will reduce the number of investment opportunities for investors who appreciate dividend income.
The effects of increasing dividend taxes will also be uneven across different companies and shareholders. For example, the payment of regular dividends is essential in certain types of businesses such as real estate investment trusts, which by law must distribute most of their profits, or utilities, where dividend payments are essential. to attract investors.
Another problem is that in debates between boards and CEOs over dividend policy, CEOs may prefer to keep profits for personal reasons, such as expanding the business empire they oversee or expanding the business empire they oversee. assurance of operating from a position of maximum financial strength. Higher taxes on dividends will increase the likelihood of such personal reasons prevailing in the boardroom. This allocates more power to management and away from boards of directors and shareholders. It distorts the distribution of the company’s capital to the detriment of all constituents, except management.
Equally important, shareholders want predictability. In the normal course, boards minimize variations in dividends, even in a context of volatile earnings, in order to protect the plans and expectations of their shareholders. Thus, the best companies orient their dividend policy towards long-term performance prospects. But these second-order effects of dividend tax increases will tend to manifest in dividend policy over several years, upsetting those expectations.
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Don’t trust business leaders to explain all of these side effects to shareholders. While some CEOs make their views on dividend policy clear, many give summary summaries, such as setting dividends as a target percentage of earnings or increasing them in line with inflation. But in the current political debate, business leaders would do well to explain these second-order effects to their shareholders – as well as to the country’s political leaders.
Lawrence A Cunningham is Professor at George Washington University, Founder of the Quality Shareholders Group and Editor of The Essays
by Warren Buffett: Lessons for American Business
This article was published by Marketwatch.