As the U.S. Congress debates changes to tax policy ahead of the December 31 expiration of the Bush-era tax cuts, executive suites and corporate boardrooms have been abuzz with urgent questions about the optimal approach to returning cash to investors through dividends and share repurchases. Timing is a particularly pressing concern for the many companies that typically announce dividend increases during the December-to-March time frame each year. Given the current intense corporate interest in tax policy, we believe it may be helpful to offer our thinking on the implications of a change in the relationship between U.S. capital gains and dividend tax rates. Briefly put, we find that while each corporation’s situation is unique, these potential changes should not affect most corporations’ capital-deployment decisions.
Congress is still debating the details, but it appears likely that the relationship between taxes on capital gains and dividends, which has varied dramatically over the past century, will change again in the near future. Currently, both capital gains and qualified dividends are taxed at 15 percent in the United States. If new tax policies take shape, as most experts expect, then the U.S. capital gains tax rate could increase to 23.8 percent, and taxes on qualified dividends could increase to the individual marginal tax rate, which would be in excess of 40 percent for the highest marginal tax bracket.
Whatever the next change in U.S. tax policy and tax rates happens to be, it will almost certainly not be the last change that executives see in this decade. Yet no matter where tax rates go next, many classes of investors will continue to seek U.S. stocks with a stable cash-return component and will take a positive view of regular dividends and share repurchases. To be sure, certain classes of investors will be impacted, perhaps meaningfully, by a dividend and capital gains tax-rate differential. And the right mix of dividends and repurchases will vary from one company to the next, depending on the overall tax regime, the specific tax situation of a company’s shareholders, the solidity and stability of a company’s finances, and other factors.
That said, we believe that potential changes in tax policy—and in the differential between dividend and capital gains tax rates—should not affect how most companies decide to distribute excess free cash to shareholders. Historically, corporate payouts and equity valuations have been far more influenced by macroeconomic conditions and the performance of individual companies than by changes in tax policy. What’s more, better than half of U.S. equities are in the hands of tax-exempt or tax-deferred investors. Changing tax rates would not influence their decisions to buy, sell, or hold. For that matter, even taxable investors often prefer the more stable income that regular dividends provide, compared with the less reliable cash returns from share repurchases, which can be curtailed without notice.
We therefore see no reason, all else being equal, for management teams and boards to let the potential for increased dividend tax rates skew their decisions regarding the levels and mix of dividends and share repurchases.