Though the fiscal cliff deal led to an increase in top tax rates, the long-term outlook is bright for stocks that pay dividends.
Senior Portfolio Manager,
Invesco Diversified Dividend Strategies
Washington's last-minute agreement on a fiscal cliff deal concentrated primarily on tax policy — including a higher dividend tax rate for high-income investors. History has shown, however, that the tax treatment of dividends has not hindered the relative outperformance of dividend-paying stocks over the long term.
The fiscal cliff and dividend taxes
In 2012, the top tax rate on dividends was 15%. Following the fiscal cliff deal, the top rate is now 20% for individuals with income higher than $400,000 and families with income higher than $450,000. (This comes in addition to a new tax on investment income for individuals making more than $200,000 and families making more than $250,000 — a 3.8% levy to help fund the Patient Protection and Affordable Care Act.)
We do not believe this limited rate increase presents a long-term issue for dividend investors. We are optimistic about the future for dividend-paying stocks for several reasons:
- History. It's important to remember that the top rate of 15% had only been in place for the past 10 years, after the Bush tax cuts in 2003. The outperformance of dividend-paying stocks dates much farther back. Over the past 40 years, dividend-paying stocks have outpaced non-payers by 7.1% on an annualized basis.1 For most of that time, dividends were taxed at rates much higher than 15% or 20%.
- Stewardship. Dividend-payers tend to be strong, well-managed businesses that are growing and returning capital to shareholders. That's what really matters over the long term.
- Management reaction. When dividend taxes were lowered 10 years ago, it was done on a temporary basis. Corporate management teams assumed the tax cuts would be temporary and did not broadly change their capital allocation decisions. In fact, dividend-paying stocks did not see a large boost in outperformance following the Bush tax cuts. So, if the cuts were not seen as a positive in 2003, we don't believe their expiration should be a meaningful headwind in 2013.
- Limited impact. About half of equities in the US are owned in non-taxable accounts, so the tax rate is not of significance to those investors.
More work to be done
While the bill provided some clarity on tax issues, longer-term spending issues were left unaddressed. The bill left the door open for continued negotiations in the next few months:
- Across-the-board government spending cuts were postponed for two months, meaning that the newly elected 113th Congress, which convened Jan. 3, will soon be tasked with resolving this issue. All told, these cuts would total $1.2 trillion over nine years, with almost $110 billion of that scheduled for 2013.
- The US officially reached its legal borrowing limit on Dec. 31, although Treasury Secretary Timothy Geithner has said he can take additional measures to keep the US under its limit until about Feb. 28 — at which time Congress would have to vote to raise the $16.4 trillion debt ceiling. Many observers expect lawmakers to tie the debt ceiling negotiations to a broader conversation about government spending.2
Focusing on the risks and opportunities
Invesco is closely monitoring the effects of the fiscal cliff deal as well as the implications of Washington's unresolved spending questions. We have 750-plus investment professionals who actively monitor both the risks and the opportunities that can arise from such significant events.
The manner in which Congress and the White House resolve these issues could have significant long-term consequences on the economy, the markets and investors around the globe. After the last round of debt ceiling discussions in 2011 ultimately led to an increase in the borrowing limit, Standard & Poor's downgraded the US long-term credit rating partly because of the "prolonged controversy" surrounding the negotiations.
As a global asset manager, we hope that the newly elected Congress can address our longer-term issues in a way that upholds the efficacy of the US political process and our government's ability to make sound economic decisions.