November 12, 2012

Now that the 2012 elections are over, we have some additional certainty in tax policies. Taxes will likely go up. These taxes will almost certainly include an increase in both the dividend tax rate and the capital gains tax rate, from the current 15% to 20% for capital gains and up to 39.6% for the dividend tax rate. Moreover, with the Patient Protection and Affordable Care Act, an additional 3.8% surcharge will be added to capital gains and dividend tax rates for certain income levels. And as certain other deductions are phased out, the 15% tax rate for capital gains increases to 23.8%, and taxes for dividends nearly triples to around 44%.

As has historically been the case, increased dividend and capital gains tax rates can negatively impact stock returns in coming months and years. When taxes are set to triple on a significant segment of the investing population overnight, you can bet that this will have a detrimental impact on stock market valuations.

In general, with an increase in tax rates, investors who rely on income from dividends and capital gains will expect a lower return on their investments, since the increased taxes reduce expected returns for stocks. This in turn reduces demand. Reduced demand for stocks means stagnant or reduced prices, which in turn detrimentally impacts stock funds such as the C, I, and S Funds in the Thrift Savings Plan.

This is not meant as a value judgment, this is math. When returns are suddenly and predictably reduced by what the government takes, investor expectations are changed.

I know what many readers are thinking: TSP funds are tax-advantaged accounts, both for regular and Roth TSP accounts. Therefore TSP participants do not have to worry about increases in dividend or capital gains tax rates. While true, this unfortunately misses the larger picture. Tax-advantaged accounts invested in stock funds – TSP and otherwise – make up only a portion of the overall stock markets. Many stock market participants will pay increased dividend and capital gains tax rates, and these expected increases in taxes will cause these investors to re-calculate their investment decisions post-election. These investors might either sell a portion of their investments to reallocate into investments with fewer taxes (like tax-free municipal bonds), or they will just not invest at all and wait for a fall in prices until the expected returns readjust to something more advantageous. This will in turn at the very least keep markets stagnant, or will drive stock markets lower. So all investors, TSP participants included, will be adversely impacted by higher tax rates.

And importantly, the new tax rates will differentiate between dividend taxes and capital gains tax rates, with dividends paid at a higher tax rate than capital gains. This means that some companies will opt for a lower pay-out of dividends in favor of ways to increase the share price of the stock, due to the preferable capital gains tax rate (e.g., selling a stock that has risen is taxed less than a higher dividend from the stock). As we experienced in the 1990s, however, this can increase company management incentive to manipulate the price of its stock through opaque means, or at the very least it can drive companies to buy back shares of their own stock even if the price is over-valued. In my opinion, dividends are preferable because they are transparent evidence that the company is making money and returning a portion to investors.

One corporation – IDT Corporation – has already taken action to reduce its dividend payments for 2013. On October 23rd, it announced the payment of a special dividend on November 13th, followed by the suspension of dividend payments for 2013, specifically citing expected dividend tax increases:

“With the uncertainty surrounding the federal tax treatment of dividends, including the scheduled December 31st expiration of the 15% federal tax rate on dividend income, our stockholders are best served by paying this dividend now. We have the flexibility to pay the special dividend while maintaining our strong balance sheet and continuing to invest in the growth of our telecom and other businesses. We do not expect to pay a regular dividend for the four quarters of fiscal year 2013, and we will monitor our operational results, cash needs and anticipated performance to determine the best way to deliver value to our stockholders going forward.”

Paying a special dividend now takes away from dividends next year – and thus, potentially, from expected returns.

Certainly, some suggest that an increase (even a tripling) in rates might not detrimentally impact dividend-paying stocks. The investment fund company WisdomTree, for example, has a long discussion of why dividend stocks were not impacted by the 1993 increases in dividend and capital gains tax rates (see “What Could President Obama’s Plans for Dividend Taxes Mean for Financial Markets?.

It is useful to point out that even though President Clinton raised taxes during his administration in the 1990s – from which WisdomTree takes as a starting point to measure 10-year returns – he also cut the capital gains tax rate in 1997 (but importantly, not the dividend tax rate), from 28% to 20%. This in part helped to propel the impressive stock market returns in the 1990s – together with a friendly Fed, the “Great Moderation” after the Cold War, and of course the internet bubble…

And as WisdomTree notes, there really aren’t any alternative investments that would be attractive now. Bond rates are abnormally low. Interest on bank accounts is a joke. Commodities such as oil, gas, and precious metals are speculative at best.

And rates on investment income from bonds will go up with individual tax rates as well. There is a real threat of inflation in the coming years, so any investment in bonds will have to take into account the sudden increase in inflation – and decrease in the value of bonds – in the not-too-distant future. Those with a passing memory of the 1970s know what this can do to an investment portfolio, in both bonds and stocks.

Others are less sanguine about the impact of a sudden and dramatic increase in tax rates, with one investment advisor suggesting that stock markets will fall 30% due to the increase in dividends and capital gains. Of particular note is the following example:

“Consider a stock trading at $100 that pays a $10 dividend every year. Under current law, an investor pays a 15% tax on that dividend, so he gets to keep 85% of it, or $8.50. So the after-tax yield on that stock is 8.5%. After year-end, under current law, the top dividend tax rate will rise to 43.4% from 15%…So on Jan. 1, an investor won’t keep $8.50 of that dividend—he’ll pay a 43.4% tax and keep only $5.66. Suddenly, a stock that yielded him 8.5% now yields only 5.66%. If 8.5% was the after-tax yield that investors demanded in order to allocate their capital to that particular company, then 5.66% will not be sufficient. That company’s stock price will have to fall until it once again offers an 8.5% after-tax yield. Precisely, the stock price has to fall by the percentage difference between $8.50 and $5.66. It will therefore fall to $66.60 from $100—that’s 33.4%. And it’s also a good first approximation of how much the overall stock market will fall when dividend taxes rise to 43.4% from 15%.”

This is an example of how incentives matter and how policies have impact, whether it’s dividend tax policy, the Fed’s historically low interest rates, or massive deficits causing a freeze to the pay of the federal workforce. We are all impacted by a slow-growth economy and massive deficits, even those who serve in the federal government and in the military. Are we prepared for a decrease of up to 30% or more in the C, I, and S Funds due in part to these policies?

At the very least, higher expected taxes for capital gains and dividends will act as headwinds on stock markets in the coming months. Coupled with uncertainties related to the “fiscal cliff” at the beginning of 2013, stock markets have already begun to re-adjust. I’ve followed Strategies II and III in TSP Investing Strategies as the markets have fluctuated this year, and I am prepared to implement Strategy IV depending on how the markets re-adjust in the coming months. While I hope for the best, I continue to prepare for more turbulence ahead.

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