A First, and Last, Hurrah for Dividends?

Corporations are pulling out their checkbooks and paying shareholder dividends at the fastest pace in years, putting money in the hands of investors who can use it for debt repayment, holiday presents or anything else they choose.

Enjoy it while it lasts. This happy state of affairs, so long in coming, may not go on much longer.

For most of the past two decades dividends were largely ignored. Money managers and their clients focused on share price appreciation, which historically has been the larger component of a stock’s total return (the sum of price appreciation and dividend payments). But price appreciation has been hard to come by during the largely flatlined decade since the dot-com bust.

Bloomberg reported this week that corporations are paying special dividends, on top of their regular quarterly distributions, at four times last year’s pace. Commerce Bancshares Inc. reported a lot of happy shareholder feedback in the wake of its $1.50 per share payment in early November. IDT, a telecommunications company in New Jersey, pulled planned dividends from 2013 into 2012. Across the board, companies are giving excess capital back to shareholders. Other companies, including Apple as of earlier this year, have instituted regular quarterly dividends or have raised their payout rates.

It would be nice to think that companies are trying to share the success of the business with its owners, or enabling shareholders to take advantage of more promising investment opportunities elsewhere. However, what we are seeing is mainly a temporary burst of payments to take to take advantage of the current tax law, under which dividend income is taxed at 15 percent.

If President Obama gets his way and tax rates on dividends rise sharply, it seems likely corporate payouts will dry up again. Not only will Americans lose this source of income on their savings and investments – and income is something they can’t get on their savings almost anywhere else these days – but corporations that cannot return cash to their shareholders effectively will look for other places to deploy it. Many of those places will be overseas.

Instead of collecting more tax on dividends after rates go up, the government is likely to end up collecting less, since there will be less money distributed as dividends to tax.

Dividends that qualify for the current 15 percent federal rate (lower for some taxpayers) represent business income that is taxed twice. The first tax is paid by the corporation itself, at rates up to 35 percent. With the government taking 35 cents of every dollar of profit, dividends must be paid from the 65 cents left over.

Apply a 15 percent federal tax rate to the shareholder who receives the dividend, and the total tax bite is about 45 cents of every dollar of profit. Additional taxes in many states take even more. And that is under the current system, which Obama and fellow Democrats see as unfairly biased toward the wealthy.

Under the president’s proposal, the top individual tax rate on dividends would rise to 39.6 percent, plus the additional 3.8 percent tax to support Medicare that takes effect next year. Thus, Uncle Sam could claim more than 43 percent of the 65-cent share of corporate profits that shareholders receive as a dividend. Add something for state taxes, and the total tax bite on dividends for shareholders rises to around 50 percent, more or less.

The net result: Federal and state taxes would consume around two-thirds of every dollar of corporate profits that is distributed to shareholders. Business owners would get to spend only the one-third that remains.

This will be an enormous deterrent to paying dividends at all, and it explains the rush to pay dividends before rates rise. As David M. DeSonier, a senior vice president at Leggett & Platt, a diversified manufacturer based in Missouri, told The New York Times, “If we can help our shareholders avoid taxes and keep more of their dividends, we’ll do it.” Leggett & Platt moved its fourth-quarter dividend payments from January to December to be sure its shareholders locked in the 15 percent rate.

There is an alternative tax scenario that Democrats might accept and that would still encourage corporations to pay their shareholders. We ought to let corporations deduct dividend payments, just as they now deduct interest on capital that they raise by incurring debt. This would eliminate the double taxation on income that is distributed to shareholders, while income retained in the corporation would continue to be taxed at corporate rates. If we eliminate double taxation on dividends, it becomes easier to justify applying to top individual income tax rate to dividends that shareholders receive, rather than a preferential rate, such as the current 15 percent.

I hope something sensible, maybe along these lines, emerges from the fiscal negotiations that are just getting underway. Otherwise, the efforts toward fiscal responsibility and tax fairness may easily backfire and send American capital overseas in search of more fertile places to work.

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