It has been another week of continuous salvos between President Obama and House Speaker John Boehner over the fiscal cliff debate. Both the President and Speaker of the House had tones of being conciliatory yet, combative. President Obama is evangelizing the platform not to extend tax increases for households making over $250K per year, which comprises his core constituency. The Republicans vow to extend the Bush era tax cuts across all income levels. As the United States hurtles towards the fiscal cliff, we are forced to examine the various effects policy measures that will shape both the political and economic discourse come 2013. Either people have to start reading, "Getting to Yes" by Roger Fisher or hope the Mayans are right about December 21, 2012.
In examining the potential effect of expiring tax policy on dividends, it is clear that the mere threat is driving investors from the market. The current maximum tax rate on dividends is 15% and because of this, investors have been able to put their personal savings in higher yielding stocks and ETF's. A look at the general mechanics of rates of return will illustrate why this is the case quite clearly. To do this and to set the context for the rest of this article, we will set a few constants. First, the risk free return is 1.7% as per the yield on a U.S. Treasury 10-year bond as on 12/13/2012. Given that the rate of inflation is about 2% for the year 2012, one will actually lose money by investing in the risk-free asset.
As an individual with savings, one must seek alternatives for growing wealth. With this in mind, use a dividend paying ETF to illustrate the current scenario in dividends. Ticker symbol SDY was bought by our investor at the $51.98 closing price on 12/31/2010 and wants to know the return through 12/30/2011 where the closing price was $53.87. Our dividends received on one share totaled $1.74. Paying a 15% tax on this, our investor received $1.48. To calculate our return:
Just to illustrate where this investment stands vis-à-vis the market, we'll apply the capital asset pricing model to show the required rate of return for comparison. For this we use 7.42% as our market return since 1980 when S&P volumes first topped the 100 million mark. This rate also included reinvested dividends. Additionally, beta of this ETF is .86 according to SPDR.
As this illustrates, this fund is a decent investment since it falls just under the required rate of return, it includes a dividend, and it is an S&P 500 index fund so it is a diversified asset. As an investor, this is a good savings tool since the money invested will appreciate at a significantly faster rate than the risk free asset.
This type of savings is in jeopardy. Under the pending legislation, which if not averted, will take hold on January 1, 2013 the Bush era tax cuts are set to expire. We all know that. We've all heard that out of a million pundits. What does it mean? In regards to dividends, it means everything. As we've discussed, the current maximum tax rate on dividends is 15%. If these tax cuts don't get extended, particularly for the households making over $250K, the tax rates on dividends increase to regular income tax. For our nation's highest earners, this rate becomes 39.6%! And we're not finished. Because of the Affordable Care Act, we can add on to that a surtax of 3.8% and the tax rate on dividends becomes 43.4%. Now let's apply these taxes to our 2011 SDY rate of return and see what happens. The $1.74 dividend gets taxed at 43.4% and our dividend becomes $.98.
Our return becomes a paltry 5.53%. Compared to the required rate of return, this isn't even close! If doesn't even satisfy the risk premium of 5.81% (7.42-1.61). Is it any wonder now why the markets have sold off since the reelection of President Obama? It's not a political statement by any means. It's a defensive maneuver by families making over $250K to move their savings to safer assets which, though there is a lower yield, there is security of the money. Bond ETF's and CD's have greater yields than the risk free asset without the risk of the stock market. This is an issue that will compound upon itself.
As high net-worth clients exit the markets, investors who are wary of price depreciation will follow suit. 300 point drops in the Dow Jones Industrial Average will appear to be soft in comparison to what could potentially happen if the United States falls from the Fiscal Cliff. As prices decline, yields will skyrocket for companies that maintain its dividends and the yield will be too great to ignore. The big question with all of this is, why sink the ship to buoy it lower? Have we not learned our lesson with the amount of wealth lost by causing massive stock selloffs?
President Obama wants to extend the tax cuts for the middle class immediately. What the President is wrestling with is how the potential effects of the new tax policy are not incentivizing the nation's highest earners to remain in the markets. Ever since President Obama's reelection, there has been a precipitous decline in the markets and companies have been announcing special dividends before year-end. The retirement issue, which is already a problem, could become a full-on crisis if tax benefits are not extended. Once again, We the people are at the mercy of our elected officials.