“It seems inevitable that taxes on qualified stock dividends will increase in 2013. The only question is by how much. In the absence of new legislation to the contrary, the top federal rate on qualified dividends will jump from 15% currently to 43.4% (top income tax rate of 39.6% plus 3.8% Obamacare tax on unearned income). Conventional wisdom holds that any major increase in taxes on dividends will operate to the detriment of high-dividend stocks by virtue of making them less attractive on an after-tax basis relative to other income investments.
“The converse was certainly demonstrated in 2003, when Bush decreased the tax rate from 39.6% to 15%. That year, high-dividend stocks were especially strong.
“In this article I will review some studies that address the issue of how high- dividend stocks have fared during periods of high or rising tax rates on dividend income. The overall message is that although high-dividend stocks may be in store for several months of underperformance, their longer-term attractiveness is likely to remain intact.
“The short-term impact (next six months) is likely to be negative. The first table below [click the thumbnail to see the whole table] (courtesy of John Davi of Morgan Stanley) shows the relative performance of the top third of stocks by dividend yield compared to the entire market in the months surrounding increases in the spread between the tax rates on dividends and the rates on long-term capital gains (1975-2012). During the year before the dividend tax increases, high-dividend stocks performed close to the broad market. However, during the six months following the rise in dividend taxes, the high-yielders lagged the overall market by 3%. After the six months of lagging, however, dividend stocks actually outperformed in months seven to 12 by a little over 1%.
“The long-term impact could be favorable for high-yielding stocks. The second chart from John Davi shows that from 1970-2012, the top-third of stocks in terms of dividend yield outperformed the overall market, regardless of the relative tax rates on dividends and long-term capital gains. Paradoxically, the margin of outperformance for high- yielding stocks was greatest during those periods when dividends were most heavily taxed compared to capital gains. I would not conclude that high taxes are good for high-yielding stocks. Rather, I interpret these results to indicate that the investment climate, such as whether value stocks are favored, is a more important determinant of relative performance than is the relative tax rate on dividends.
“In addition to the data from Morgan Stanley that we have already seen, studies from Wisdom Tree (‘What Could President Obama’s Plans For Dividend Taxes Mean for Financial Markets?’) cover even longer historical periods. These studies too point out the historical outperformance of high- yielding stocks as a group during a wide variety of tax environments. The third chart shows the maximum tax rate on dividend income from 1927-2011. During these decades, the federal tax rate on dividends has been as high as 91% and as low as 15%. In fact, the 15% tax rate that has been in effect from 2003-2012 is historically anomalous.
“High-yielding stocks outperformed the broad market during periods of both heavy and light taxation. The table below shows the price and total returns of high-yielding (top 30%), broad market, and low-yielding (bottom 30%) stocks. On an after-tax, total return basis, the high- dividend stocks outperformed the other groups during three of the four periods. Implications: The decision to hold high-yielding stocks should not be made with taxes in mind as a primary consideration, because historically, their relative investment performance has not depended on the tax environment. Of course, this does not guarantee that high-dividend stocks will outperform in the future to the extent that they have in the past. Nonetheless, these historical observations are reassuring for investors who rely on dividend stocks to meet their objectives. Precedent suggests that the coming tax hikes are not a reason to abandon any dividend-oriented strategy you may be following.”
Dr. Marvin Appel and Gerald Appel, Systems & Forecasts, 11/29/12
