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?

Robin Hood: Man in Speedo

President Obama has tried to position himself as a post-partisan Robin Hood, protecting the interests of the working class against rapaciously greedy working professional married couples with $250,000 incomes (bling-bling). He better stock up on Speedos, because his tax policies will leave us treading water for the next decade.

As I discussed yesterday, a dart-throwing monkey could put together a list of Obama's talking points for any given speech on tax policy. But, all fun aside, the posture of the U.S. political left on tax policy contains the seeds of its own undoing.

So what's the major flaw with the direction of Obama's tax policy?

The Obama administration and its cheerleaders generally believe that the solution to any budgetary issue is to "raise taxes on the wealthy" and to "close tax loopholes for greedy corporations." They make exceptions for favored industries and favored campaign donors, but they stay pretty consistent on message.

On the surface, this seems like good politics. If you convince 98% of the voting public that 2% of the voting public is not paying its "fair share," you can generate healthy majorities in favor of higher taxes on the 2%. At a minimum, you can use the Robin Hood card to get yourself elected or re-elected!

However, the political left harbors a desire to expand government and socialize the funding mechanism for various services (health care, green energy, affordable housing, etc.). The left's appetite for new programs requires new tax revenues. Mind you, we're not talking 'new tax revenues to reduce the trillion dollar budget deficit.' We're talking 'new tax revenues to pay for the President's new stimulus plan,' or 'new tax revenues to pay for Obamacare.'

Let me pause and note that politicians on the right have been complicit in the federal spending orgy that created our long-term budget crisis. However, the emergence of the Tea Party has created significant pressure on the right to end its complicity.

So the left needs new revenues, and it boldly declares class warfare on working professionals and their distant cousins in Martha's Vineyard and Sun Valley, the "millionaires and billionaires." In its thirst for revenues, it amends the Internal Revenue Code to create a series of "pay fors."

What do I mean by "pay for"? A "pay for" is a change to the Code that is projected to raise enough revenue to "pay for" a liberal spending objective. In recent years, Congress has enacted numerous "pay fors" without carefully weighing the consequences. One such folly was expanded 1099 reporting for small business (subsequently repealed). Another was the codification of the economic substance doctrine (which has left everyone, from the IRS to the tax practitioner community, scratching their heads).

Here's the thing about "pay fors." Tax policy driven by "pay fors" is no tax policy at all. "Pay fors" are a series of effectively random changes to the Code that are driven by political momentum to pay for a desired spending program. It is impossible to verify that the projected revenues from a given legislative change ever materialize.

And here's the other thing about "pay fors." When the political left closes a "loophole" to fund a new spending program, the revenues from that "loophole" are not available for deficit reduction. For example, President Obama would "pay for" the cost of his proposed stimulus act (ahem, "jobs plan") by raising taxes on the various bad apples described above (working professional married couples, millionaires and billionaires, oil and gas companies, private equity fund managers). However, if that proposal is enacted, we are still facing trillion dollar deficits as far as the eye can see. If the revenues of a new spending program are financed with a "pay for" that changes the existing tax rules, we're effectively trading water.

In this sense, the tax policy agenda of the political left contains the seeds of its own undoing. Sure, we can "pay for" new spending programs (the new stimulus act, Obamacare, whatever) by increasing taxes on the "wealthy" and "big corporations." But we're left treading water from a long-term budget perspective. Meanwhile, the Code gets more complex, and many businesses and individuals spend more time and money on non-productive tax planning and tax compliance activities.

The only way to finance the spending objectives of the political left and to tackle our long-term fiscal challenges is to increase taxes on everybody: rich, upper-middle class, middle class, lower-middle class, and poor. Maybe the left will convince voters and taxpayers that we should move in that direction. I wouldn't put money on that bet.