In One Up On Wall Street (p. 19), Peter Lynch once remarked that “if anybody’s responsible for the disappearing dividend, it’s the U.S. government, which taxes corporate profits, then taxes corporate dividends, for so-called unearned income. To help their shareholders avoid this double taxation, companies have abandoned the dividend in favor of the buyback strategy, which boosts the stock price. . . Reducing the supply of shares increases the earnings per share, which eventually rewards shareholders, although they don’t reap the reward until they sell.”
I love everything about this Peter Lynch quote, even including the editorial aside that subtly trashes the notion of referring to dividends as unearned income in our tax code. It’s dumb to go through life thinking that the money generated from your labor is the most legitimate source of ways to make money; applying the skill to acquire in ownership interest in a business that is generating profits, and by definition, delivering value to its customers is no less worthy of an achievement.
The reason why the government, acting through the IRS, uses the phrase “unearned income” is to differentiate between wages earned through your own labor, compared to the money that you make through ownership interests (capital gains and dividends).
Generally, the taxes you have to pay for your dividends and capital gains is lower than the amount of tax that you have to pay on your wages. That is to say, if you are in the 10% or 15% wage bracket, you pay 0% on capital gains and dividends. If you fall within the 25%, 28%, 33%, or 35% wage bracket, you pay 15% on your dividends and capital gains. There is an additional 3.8% tax to pay for Obamacare if you are bringing in $250,000 from wages (and are married filing jointly), bringing in $200,000 (if you are single or head of household), or $125,000 (if you are married filing separately).
The reason why capital gains and dividend taxes is lower than wages is because (1) you are already paying a tax, sometimes in the vicinity of 35%, on the profits that you generate inside the corporation, except the company pays this to the government before you see any of it, and (2) there is a “risk” that no profits or dividends will materialize when you make an investment. That is, if you make $10 per hour and work 10 hours, you are going to get your $100 and then pay taxes. But, if you buy Exxon stock, there is no absolute guarantee that your investment will increase and you will collect dividends. The risk may be remote (much less than 1%), but nevertheless, there is no legal guarantee.
My potential concern over the next 20-30 years is that we will see increases in the capital gains and dividend tax rates (to try to shore up the national deficits) and this will cause large American companies to operate on what I call the “Disney Model” or the “IBM Model” in which case the dividend takes up 15-30% of cash flow and the company spends 3,4, or 5x as much money to buy back stock as paying dividends (they will do this on tax efficiency grounds).
This is an area of investment where I don’t think history is much use as a guide in trying to determine how corporate dividend policy will react to rising taxation rates. The legality of stock buybacks was not apparent until the early 1980s (before that, corporate executives were shy to conduct buybacks on the fear that it could be seen as trying to manipulate the stock price), and the past thirty years have been a time of directionally lower dividends and capital gains taxes.
If dividend taxes cross the 30% or so rate, the concern is that the amount of profits that do not need to be retained to grow the company will instead be disproportionately allocated to buybacks over dividends in the name of tax efficiency. This will be good at raising earnings per share, and eventually, stock prices, but will be less useful in the immediate sense; a 7% dividend increase automatically hits your pocket within three months, whereas a buyback that increases earnings per share by 7% does not have to be recognized in the stock price.
The answer to solving this problem is to follow Abraham Lincoln’s counsel that the best thing about the future is that it happens one day at a time. When the changes come, we can monitor them on a company-by-company individual basis. Companies like Disney and IBM have already set up business models that rely on stock buybacks over dividends, whereas companies like AT&T and Altria have business models that prize using cash flow to pay dividends over buybacks. There are two enemies to dividend growth policies at Fortune 500 companies: one is compensation packages based on stock price (which incentivizes increases in earnings per share due to buybacks) and the other is increases in dividend tax rates that incentivizes the more tax efficient nature of stock buybacks.