Do Dividend Stocks Pose Hidden Risks With The Fiscal Cliff Looming?

Jul.13.12 | About: iShares Select (DVY)

Recently, there's been an uptick in general media coverage about dividend growth investing. There's been a proportional increase in articles questioning whether dividend stocks are risky and will crash. The primary argument against dividend stocks is that the fiscal cliff, which will tax top earners up to 39.6% on their dividends, is going to crater dividend stocks like the Tunguska Event. Take a look at this article by Donald Luskin, where he says:

Unless current law is amended before year-end, the stock market has to fall by at least 30%. It's all about how dividends are taxed-and the reality that we are facing the biggest single hike in dividend tax rates in history.

What do I think of that? Well, if I may borrow a line from Will Smith in I, Robot:

*sneezes* Sorry, I'm allergic to bull!@#$

Breaking Down Dividend Stocks: Point 1, History

It's important to analyze this policy (dividend taxation at top income bracket levels) in a historical context. It's very easy to generalize and say "the dividend tax is tripling, this is the end of the world for stocks" but with a little effort, it becomes clear that this isn't true. (Please note that this article is written under the assumption that the dividend growth strategy does indeed work. If you're interested in why, see The Only Investing Strategy You'll Ever Need by Marc Lichtenfeld -- it's a good primer.)

The first (and most important) piece of history to analyze is the history of the dividend tax rate. While everyone's freaking out over the tax hike, it's important to realize that the current 15% top dividend tax rate has only actually been around since 2003 when our good President Bush actually wanted to eliminate dividend taxes entirely.

But here's a chart of dividend tax rates through history, which I obtained from Richard Shaw's article US Dividend, Cap Gains Tax History: Possible Relevance to Future Taxation. You should read the article - it's a great history lesson.


Now, while high taxes are certainly evil and I hate them as much as the next red-blooded American, let's examine the performance of dividend stocks over the period from 1985-2002, when dividends were fully taxable at the top income bracket tax rate (which ranged from a low of 28% to a high of 50%). I'm using Coca Cola (KO), Exxon Mobil (XOM), Procter and Gamble (PG), and McDonald's (MCD) as examples of blue chip dividend stocks. Please note that the chart does not incorporate reinvested dividends.

(click to enlarge. Source: Google Finance)Click to enlarge

The chart speaks for itself. Even ignoring the late '90s bubble, dividend stocks did pretty well in the face of top-tax-bracket taxation, huh?

Commentators like Luskin who proclaim that the stock market will suffer a "30% collapse" due to dividend taxation certainly aren't taking a page out of the history book. It's also interesting to note that post-2003, there wasn't a mad rush into dividend stocks -- PG and KO performed fairly in line with the broader market, and the outperformance of MCD and XOM seems to be fairly related to strong EPS growth.

Click to enlarge

XOM Earnings Per Share TTM ChartClick to enlarge

XOM Earnings Per Share TTM data by YCharts

Point 2: Bond Interest Tax

The other thing to consider is that municipal bonds are the only form of tax-free income available. While Treasury bonds are exempt from state and local taxation, they are still fully taxable as income by the federal government at the exact same brackets as dividends would be under the slated increase. So until and unless bond yields exceed dividend yields (which they currently don't), dividend stocks are still the superior option for yield. While high yield bonds can be a good part of a retirement portfolio, it would be very unlikely to see a widescale flight from "safe" dividend stocks to "risky" junk bonds. Thus, at least in the near term, quality dividend stocks still provide the best after-tax yield around.

Point 3: Retirement Account Effect

I have a personal theory on why dividend taxes seemingly don't have a huge effect on stock market. Please take the theory with a grain of salt, because I don't have solid data to back it up, but here goes.

A look around SeekingAlpha suggests that Dividend Growth Investing is a strategy primarily followed by those saving for retirement. There are exceptions, of course, but most of the readers I've interacted with hold dividend stocks like the ones I mentioned in a retirement account. (The retirement market in the US is somewhere north of $15 trillion.)

Well, what do you know about retirement accounts? They're either tax-deferred (traditional IRA/401k, etc) or tax-free (Roth). Thus, for a lot of dividend growth investors, dividend taxes are immaterial. I would also guess that the average American's retirement account balance far exceeds their taxable standard brokerage account balance.

Not proof, just a thought on why the aforementioned phenomenon might occur.


Taxes are bad because they take money out of consumers' hands and put it in the government's hands. However, a look at history suggests that investors shouldn't be all that worried about the performance of their dividend stocks in the face of the fiscal cliff.

Dividend growth investing has a long term history of success, and any dip caused by panic over the fiscal cliff should be viewed as a buying opportunity. Dividend stocks did superbly in the 1985-2002 period, when dividends were taxed in the top bracket.

There's no reason to panic.

Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources and management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.

Disclosure: I am long PG.