Sunday, November 11, 2012

Why Tax Increases Could Lead to More Buybacks

(Note: Since this article was published, dividend tax rates were increased as expected, but in-line with long-term capital gains. This is a more positive outcome than the one described in the article where dividends and capital gains were taxed at different rates.)

It now seems certain that dividend tax increases are on the way starting in 2013.

The point of this post is not to argue the wisdom (or lack thereof) of a dividend tax increase from a fiscal standpoint, so I won't add to that discussion here.

Instead, I want to explore how tax rate changes could affect corporate distribution policies, especially if dividend tax rates end up being higher than long-term capital gains tax rates.

Even things up

Recall that in 2003, tax rates on qualified dividends were lowered to 15% and, more importantly, were brought in-line with long-term capital gains tax rates for the first time in many years.


The initial effect of the equalized tax rates, according to a paper by the National Bureau of Economic Research, was that "firms adjusted their distribution policy (specifically, dividends versus share repurchases) in a manner consistent with the altered tax incentives for individual investors."

Indeed, it stands to reason that another tax change in 2013 would similarly impact buyback and dividend policies.

Buybacks still surged

Despite the reforms that reduced the tax disadvantage of dividends, buyback activity has actually surged since the end of 2003 and has trumped dividend payouts 1.68-to-1 through 2011.

Source: Birinyi Associates and FRB Z.1.
We've previously discussed the reasons why buybacks can be more attractive to management teams, but investor preference for lower tax rates on capital gains cannot account for the boom in buyback activity since 2004 as tax rates have been equal over that time period.

That might change starting next year if no legislative effort is made to keep dividend and long-term capital gains taxes the same, as it would re-establish the tax disadvantage of dividends.

Source: Goldman Sachs
A tailwind for buybacks

Don't get me wrong -- I do not think that companies will stop paying dividends or stop increasing their payouts in a higher and unequal tax rate environment. Far from it.

It's entirely possible in such an environment, however, that relatively lower taxes on capital gains could add more fuel to buyback activity. If that's the case, dividend growth rates may be lower than what they might have been in an equal tax environment.

It's also possible that some younger companies that might have considered paying a small dividend in an equal tax environment may opt to focus on buybacks instead.

It will be interesting to see how it plays out, but unless Congress keeps tax rates on dividends and long-term capital gains the same (even if they are both increased) I expect to see buybacks continue to account for the bulk of total distributions.

Source: Birinyi Associates and FRB Z.1.
What do you think? Please share your thoughts below.

Thanks for reading!


@toddwenning on Twitter