Corporate dividends have flourished recently, but a coming hike in the federal tax on dividends could discourage the renewed corporate interest in making dividend payments.
While dividends took a beating in 2008 and 2009 in the wake of the financial crisis, “they have now come back and set a brand new record,” says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. He expects S&P 500 companies to pay a record $276 billion in dividends this year, surpassing the previous record of $248 billion paid in 2008.
Silverblatt, pictured at left, notes that 400 of the S&P 500 companies currently pay dividends, the highest level since 1999, and predicts almost 70% of those that pay dividends will increase their payments this year. Ten S&P 500 companies initiated dividends so far this year, including tech giants Apple and Dell, following the 22 companies that did so in 2011.
By historical standards, companies are still not being that generous, though. S&P 500 companies currently pay dividends equal to 31% of their reported earnings, which falls far short of the historical average of 54% since 1936.
Silverblatt links the pick-up in dividend payments with the improvement in corporate earnings. “Dividends trail earnings,” Silverblatt says. “Companies like to see several quarters of decent earnings and then they start increasing [the dividend].”
Companies currently have a lot of cash on their balance sheets, but Josh Peters, editor of Morningstar DividendInvestor, says big cash holdings “tend to make managers think more in terms of a share repurchase program, perhaps a special dividend or an acquisition. Regular dividends are not really how you deal with a cash pile-up.”
Peters, pictured at right, also notes the demographic shift that’s occurring. Baby boomers preparing to retire are much less likely than their parents to have a defined-benefit pension and they’re less confident that stocks will post a healthy return every year. “You need that dividend that you can depend on,” he says. “As individual investors realize that dividends are much more important than they thought back in the ’90s, you’re starting to see some institutional investors take more of an interest and in turn, companies are taking note.”
But unless Congress intervenes, the tax on dividend income is scheduled to rise from the current 15% to a maximum rate of 43.4% at the end of this year. “If you pay me a dollar dividend Dec. 31, I get to keep 85 cents,” Silverblatt says. “If you pay me Jan. 1, it's under 57 cents.”
He argues that in the current low-interest-rate environment, investors will see dividend payments as attractive even at the higher tax rate. “Investors do not have a lot of alternatives.” And of course, many investors hold shares in tax-advantaged accounts such as 401(k)s or IRAs.
Companies are another matter. “Companies are going to look at [the higher tax rate] and say, ‘Should I be increasing my normal dividend at this rate if my holders don’t get to keep as much?’” Silverblatt says. “We don’t think anyone will say, ‘I’m not going to pay,’ but some companies might divert some money from dividends to buybacks. It will put some pressure on dividends and probably add to buybacks.”
He also expects some companies that are scheduled to make dividend payments next January to try to shield shareholders from the tax hike by making those payments late this year, a practice he calls Q5 payments. U.S. companies paid $21 billion in qualified dividends in January 2012, Silverblatt notes. “Companies that pay in January are going to move up those payments and pay in December.”
Morningstar’s Peters argues that the tax increase won’t alter companies’ dividend practices, and cites General Mills, which has been paying a dividend without interruption for 113 years. “Its individual shareholders are certainly counting on getting those dividends and seeing those dividends grow,” he says. “If dividend taxes go up, I don’t think that’s going to change [General Mills’] dividend policy.”
The scenario might be different for companies that only started paying a dividend recently, Peters says. “What you may see is that companies with immature dividend policies, that maybe have only started paying dividends over the last eight to nine years, when we had low tax rates, may say, ‘Oh, so we’re taking the dividend away.'”
Anjolein Schmeits, clinical professor of finance at New York University’s Stern School of Business, says companies have paid out more dividends since President George W. Bush lowered the dividend tax rate to match the rate on capital gains. “But that also coincided with higher corporate profits.”
Whether it’s best for companies to make payments to shareholders in the form of dividends or stock repurchases “will definitely be affected by taxes,” Schmeits says. “But corporate profits are another important factor that impact dividend payments, clearly.”
See a slideshow highlighting some S&P 500 companies that pay dividends.