Wednesday, February 22, 2012

Obama's Dividend Assault: Silver Lining for Private Equity?

[1] Among the proposals in the 2013 budget, Team Obama wants to increase the tax rates on dividends received by the "rich." Obama defines "rich" to include families that earn $250,000 annually (and single individuals that earn $200,000).

(Any higher thresholds would substantially reduce the amount of taxes raised from increased taxes on the "rich." As government's thirst for revenue intensifies, expect the threshold to drop. It's all relative. A family that earns $150,000 is living large compared to a family that earns $50,000. And an individual that earns $75,000 is sampling the good life compared to an individual that earns $25,000.)

[2] In today's Wall Street Journal, the editors took aim at President Obama's "assault" on dividends. (Sub. required; thanks to Paul Caron for the link.)
Mr. Obama is proposing to raise the dividend tax rate to the higher personal income tax rate of 39.6% that will kick in next year. Add in the planned phase-out of deductions and exemptions, and the rate hits 41%. Then add the 3.8% investment tax surcharge in ObamaCare, and the new dividend tax rate in 2013 would be 44.8%—nearly three times today's 15% rate.

Keep in mind that dividends are paid to shareholders only after the corporation pays taxes on its profits. So assuming a maximum 35% corporate tax rate and a 44.8% dividend tax, the total tax on corporate earnings passed through as dividends would be 64.1%.
The numbers are pretty shocking, but consistent with Obama's core philosophy. Obama is campaigning in 2012 as a populist Robin Hood. As many have noted, the 2013 budget is a political document at its core.

[3] I'm actually more interested in the "knock on" effects of the dividend tax increase. The WSJ editors argue that increased dividend tax rates will "make stocks less valuable." Maybe so, but probably not.

The WSJ article includes a graph that tracks reported dividend payments from 1990 through 2009. The graph suggests that corporations increased dividend pay outs in response to a dividend rate cut in 2003. Let's assume that the relationship is causal, i.e., the decrease in tax rate on dividends caused corporations to increase dividend pay outs.

What happens if tax policy changes, and dividend tax rates are increased (for those "rich" families that earn $250,000 annually and their distant cousins, the mega-millionaires and uber-billionaires)?

If there is a causal relationship between dividend tax rates and corporate distributions, we'd expect corporations to reduce distributions. However, corporations have two ways to return cash to shareholders. They can pay dividends, which is arguably good for retail investors on fixed incomes (traditionally, "widows and orphans"). And they can engage in stock repurchase transactions, which is arguably good for other investors who want capital appreciation without dividend income (and current tax leakage).

A dividend tax increase does not impact the cash from operations available for distribution to a corporation's shareholders. It simply impacts the form of distribution. Ironically, this flexibility at the corporate level makes static budget forecasts unreliable. A dividend tax rate increase may raise immaterial revenues if corporations shift gears and increase stock repurchase activity. So what's the point? Political distraction. And, if nothing else, President Obama gets to wear his Robin Hood tights and cape for his political admirers.

[4] Finally, let's assume that higher taxes on dividend income do, in fact, take some air out of the market for public equities. In other words, assume that Obama's assault on dividends "make stocks less valuable." Would this be bad for the "tens of millions" of Americans that own stock "through pension funds"?

In fact, lower equity valuations would probably benefit pension funds and their individual beneficiaries. Ironically, lower equity valuations may provide a silver lining for their private equity advisors.

I won't get into a full-blown discussion of the relationship between pension funds and private equity. Suffice to say, despite all the hype about private equity, a substantial majority of the capital for private equity managers is invested by pension funds.

Unlike high-income individuals, pension funds generally pay no income tax on dividend income (or interest income, or other forms of passive income). If increased dividend tax rates decrease equity valuations, private equity managers will have "cheaper" opportunities to deploy their investment capital. They can improve the performance of portfolio companies, strip out operating cash flows through tax-exempt interest and dividend payments, and flip investments at slightly lower earnings multiples.

Big pension funds win. Private equity fund managers win. Only small individual retail investors lose. But what else is new when government interferes with capital markets?

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