Dividend Tax Cut Effect Mixed
Seven months after Congress voted to slash the tax rate on income from stock dividends, the verdict from investors and corporate managers is decidedly mixed.
The Bush administration promoted the tax cut, which lowered the top federal tax rate on dividends from 38.6% to 15%, as part of a broader economic stimulus package. But by making dividend income more attractive to investors, the effects were expected to go beyond just putting more spending money in some people’s pockets.
Many economists predicted that the cut would boost the appeal of dividend-paying stocks compared with interest-paying bank accounts or bonds, giving the stock market overall a lift.
The change also was expected to force corporate managers to be better stewards of shareholders’ capital in the long run. Instead of holding on to earnings for their own pet projects, managers were expected to think more about returning profit directly to investors via dividends -- thereby allowing the marketplace to decide how the money should be put to work.
It’s now apparent that the tax cut has had some effect, but experts differ on whether the reality has lived up to the hype:
* Through November, 1,494 U.S. companies had raised their dividend payments this year, 219 more than in the same period of 2002, according to Standard & Poor’s. About 95% of the increases this year occurred after April, suggesting that many companies were waiting to see if the tax bill would clear Congress.
Still, the number of companies raising dividends this year is below the 1,571 that did so in the first 11 months of 1999, when the economy and the stock market last were booming.
“Companies are playing it extremely conservative in terms of how they use their cash flow,” said Charles B. Carlson, editor of the Hammond, Ind.-based DRIP Investor newsletter, which focuses on dividend-paying stocks. Even so, Carlson said he considered the number of dividend increases this year to be a decent showing.
* Some well-known corporate names have raised their dividends sharply, specifically citing the tax cut as a reason. Companies boosting their annual payouts by 50% or more included San Francisco-based Wells Fargo & Co., McDonald’s Corp., Lockheed Martin Corp. and Citigroup Inc.
Also, some companies that had never paid dividends started doing so this year, after the tax cut. Casino giant Harrah’s Entertainment Inc. in July said it would begin paying a dividend at an annual rate of $1.20 a share.
But the mega-increases have been the exception, not the rule. S&P; calculates that the total cash dividend on its index of 500 blue-chip stocks will rise 7.8% this year -- a number that doesn’t impress George Mairs, the veteran manager of the Mairs & Power Growth stock mutual fund in St. Paul, Minn.
“I’ve been disappointed with the magnitude of the increases,” Mairs said. “I think too many of the increases have been marginal. It’s the old story -- management is looking to hold on to more of the money.”
* At least one investor survey indicated that more individuals are factoring dividend income into their search for stocks. In an October survey sponsored by American Century Investments, 43% of 600 respondents said they were “now more likely to buy stocks that pay a qualified dividend than stocks that pay no dividends.”
Thirty-seven percent said they were “now more likely to consider stocks as an alternative to bonds” for income.
If more investors are chasing stocks that pay generous dividends, however, it isn’t necessarily being reflected in the stocks’ prices. Wells Fargo stock is up 13.9% since the company announced its dividend increase on July 22, barely keeping pace with an index of 18 regional bank stocks that has gained 14.1% in the same period.
Indeed, smaller stocks that pay low or no dividends have performed far better this year, on average, than big, high-dividend shares. S&P;’s index of 600 smaller stocks has gained 37.2% year to date, compared with a 24.6% rise in the blue-chip S&P; 500. But Wall Street pros say it’s typical for higher-risk stocks to lead a new bull market’s first phase. Many dividend proponents believe that bigger stocks will take over the lead in 2004 and that dividends will become far more appreciated.
“I think 2004 is going to be much more of a dividend story, just because capital gains are going to be harder to come by,” Carlson said.
In theory, at least, if the market’s advance slows, then the concept of “total return” should become more important to investors. Total return is stock price change plus dividend income.
Until the latest tax cut, investors were conditioned to favor capital gains over dividends because long-term capital gains were almost always taxed at lower rates. Now, 15% is the maximum federal tax on both.
Meanwhile, interest income, such as from bank savings and bonds, continues to be taxed at ordinary rates.
Of course, a stock entails the risk of principal loss, while a bank account doesn’t -- a significant issue for many investors. For those willing to take that risk, however, dividend income can have a substantial tax advantage over interest income.
For an investor in the 35% federal marginal tax bracket, the net return of a 3% interest yield would be 1.95%. If the same investor earns a 3% yield from dividends, the net return would be 2.55% at the 15% tax rate.
Joseph Lisanti, editor of S&P;’s Outlook investment newsletter in New York, said many investors may not focus on how much more dividend income they’re keeping until they see their 2003 tax returns.
“There’ll be bigger tax refunds for many people because of the dividend tax cut,” he said.
Dividend fans also note that a key attraction of the cash payments is that they can grow over time, raising an investor’s effective yield. That doesn’t happen with bond interest.
Some veteran investors say that although dividend income is more appealing now, it’s understandable if many investors can’t get excited about the low-single-digit yields on most stocks.
A dividend yield is calculated by dividing the annual dividend on a stock by the price the investor paid. For example, Wells Fargo’s annual dividend of $1.80 a share, divided by its closing price Friday of $58.37, produces a yield of 3.1%.
The average blue-chip stock’s yield, using the S&P; 500 index as a proxy, is about 1.6%. That’s up from the record low of 1.1% set in 2000, but a far cry from the 3% to 5% range of the 1960s, ‘70s and ‘80s. Still, that beats the national average yield of 0.5% on taxable money market funds or 1.2% on one-year certificates of deposit.
“Yield is a very scarce commodity in the world today,” said James Gipson, head of the Beverly Hills-based Clipper stock mutual fund. He said dividends aren’t a major consideration in his stock-picking strategy, although “I think in total, companies are doing the right thing in shifting more of their capital to dividends.”
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How some blue-chip yields compare
Here are dividends paid by some of the stocks in the Dow Jones industrial average, the annualized yields based on the stocks’ current prices, and the stocks’ price changes this year. (Dividend yield is calculated by dividing the dividend by the stock price.)
*--* Annual Latest stock Dividend YTD stock Stock dividend price yield change Alcoa $0.60 $37.49 1.60% +65% Altria Group 2.72 53.65 5.07 +32% AT&T; 0.95 19.76 4.81 -24% Citigroup 1.40 47.86 2.93 +36% Coca-Cola 0.88 49.96 1.76 +14% Exxon Mobil 1.00 40.05 2.50 +15% General Electric 0.80 30.72 2.60 +26% General Motors 2.00 52.97 3.78 +44% Merck 1.48 45.10 3.28 -16% Walt Disney 0.21 23.21 0.90 +42%
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Sources: Bloomberg News, Times research
