Does tax policy affect dividend payouts?

At the end of 2010, the temporary 15% tax rate on dividend income is set to expiry in the United States, barring a further extension by the Obama administration. An end of this tax cut would return the dividend tax to its pre-2003 rate of 35%.  What effect, if any, did the initial 20% cut have on dividend payouts and dividend policy?

In their paper entitled Dividend Taxes and Corporate Behavior: Evidence from the 2003 Tax Cut, Raj Chetty and Emmanuel Saez found, taking a sample size from 1980 to 2004, that a tax cut in dividends resulted in an increase in companies either initiating payment of a dividend or increasing dividends.

Specifically, the number of publicly traded companies paying dividend increased from a low of 20% in Q1 2004 to 25% in Q2 2004, which is contextually significant since the number of publicly traded companies paying dividends had been declining for two decades before the 2003 tax cut. Additionally,  in comparing the number of American companies initiating dividends compared to their Canadian counterparts (which did not experience a similar tax cut), one sees a sudden and pronounced blip on the American side after the 2003 tax cut.  Thus, the evidence seems to support that the tax cut had the desired effect of stimulating a mini dividend boom.

However, equally significant, the authors reported some interesting finding in their study which all dividend investors should be aware of:

1. In and of itself, a tax cut to dividend income tends to stimulate dividend policies or increases from moderately successful businesses. The author’s found that the firms that responded most positively to the tax cut were businesses with moderate growth prospects while the businesses in the top quintile (i.e. top 20%), who had the best growth prospects, “responded very little to the tax cut.” Studies show that moderate growth firms tend to hoard cash at the expense of shareholders, most likely because they have no economic moat to confidentially declare dividend increases annually.  The logical implication seems to be the best businesses set dividend policy with little regard to external tax forces while moderately successful businesses need to be stimulated into action. Only again, the study merely affirms Buffet’s rule of investing in the best businesses.
2. Companies with large shareholders on the board, or high institutional ownership, tend to react more favorably to the tax cut than a board full of insiders. The economic theory has been that a company controlled substantially by insiders, with little to no shareholder or institutional board members, have an incentive to hoard cash (and use that cash to reward themselves). Conversely, a company with a large shareholders on the board or institutions who need a ROI tend to support measures which favor shareholder return via dividends or share repurchases. The larger implication of the study suggests that independent boards, or shareholders wielding clout, are good for the dividend investor in general.
3. Dividend income is concentrated predominantly in the hands of high earners. Over 2/3 of all dividend income is earned by the top 10% of income taxpayers (although dividends earned in pensions funds is not included so this figure may be lower). This begs the question of whether you become rich by being a dividend investor or the rich know the key to remaining rich is to invest in dividends? Regardless, it tends to support the assertion that dividend investing is a key pillar in successful stock investing.

The question not asked in the study, given it was written well before the credit crisis and hyper-ballooning of government deficits, is what would be the effect of a tax increase in dividend income?

If part of the regulatory reforms is to create a more shareholder-friendly investing climate, then one would conclude  that the tax cut should be made permanent given that incentives to increase shareholder return would encourage boards to be more than self-serving. However, by the end of this year, will the American deficit be so large that the pressing need for increased tax revenue, and the popularist view that dividend tax cuts only favor the rich, over-ride an investor- friendly securities framework?

If you are an American dividend investor, you should call your member of Congress to discuss their position on this matter.