The S&P 500's Taxing Outlook

Includes: IAAC, QQQ, SPY
by: Market Blog

Bush-era tax breaks have provided hundreds of billions of dollars worth of incentives to buy dividend-paying stocks over the past eight years, a new study by Standard & Poor's Corp. said. But with those breaks set to expire at the end of the year, the keeper of the S&P 500 and other major stock indexes is wondering aloud whether the impending tax bite may give investors cause to back away from U.S. equities.

"Higher dividend tax rates to individual investors would require investors to re-think their net income alternatives," said Howard Silverblatt, senior index analyst at S&P Indices.

In a report issued Monday, S&P calculated that the tax cuts put in place by President George W. Bush in 2003 have saved investors in S&P 500 companies $141 billion over the almost eight years they have been in place. If you include publicly traded U.S.-based companies that aren't on the S&P 500 index, the tax savings totals $274.5 billion.

But at the end of this year, those tax cuts are due to expire, unless Washington decides to extend them. If they do expire, the maximum tax rate on dividends would jump to 39.6% from 15%. The maximum rate on capital gains on holdings of at least one year will rise to 20% from 15%.

Mr. Silverblatt said the big increase on the dividends is the bigger concern of the two for the market. However, he argued that because the current low-interest-rate environment offers income-focused investors few better alternatives to dividend-paying stocks, "the additional tax may not force many to change their investment strategies."

"The 39.6% dividend tax rate still leaves stocks competitive with CDs and Treasuries, which leaves the investor with the same risk-reward tradeoff question, just at a different level," he wrote. "With companies now issuing more debt (partially to refinance at lower rates, compared to maturity schedules), and investors appearing to accept some risk, lower-grade issues could become more attractive to income-dependent investors – the very group which tends to avoid risk.”

He also suggested the tax change might limit dividend growth in the market going forward, as companies reconsider whether to increase their payouts, given that less of the money would end up in investors' pockets. The result could be an increase in share buybacks as an alternative use of excess company cash, he said.

And that could partially offset the negative impact of the tax increase, at least over the short run.

"Buybacks are typically a short-term win-win situation," Mr. Silverblatt said. "The added buying pushes the stock price up. Even if the stock price is declining, the buyback plan should reduce the speed of the decline. Earnings per share benefits almost immediately via the lower quarterly average share count."

Of course, all these issues could prove hypothetical should U.S. lawmakers step in to extend the tax breaks or introduce new ones for investors before the end of the year - although many Washington watchers wonder whether Congress has the stomach right now to offer tax breaks to Wall Street. Nevertheless, Mr. Silverblatt noted, Congress plans "an expanded discussion" on the tax question when it returns from the summer recess next month.

Disclosure: None