Views on the integrity of global capital markets
03 January 2013

D.C. Dodges Fiscal Cliff; Investment Markets Dodge Dividend Cliff

Say what you will about the 2003 tax cuts, but they made mergers and acquisitions harder to defend. The many investors who lost billions of dollars when companies “reinvested” in overpriced, poorly executed deals in the 1990s rather than pay dividends were probably wondering why it took so long for policymakers to come to their senses. That the New Year’s deal on the so-called U.S. fiscal cliff doesn’t include pre-2003 tax rates on dividends and capital gains is likely fueling a collective sigh of investor relief in the markets that political populism won’t force us to relearn those lessons all over again.

Under the deal approved Tuesday night, U.S. taxes on dividends and capital gains would increase in tandem for families with taxable income greater than $450,000 to 20 percent, from 15 percent on Monday. The 33 percent increases will not apply to earnings from similar sources reported by those whose incomes fall below that threshold. It is a silver lining in a bill that does nothing to head off a bigger fiscal calamity produced by the accumulation of trillion-dollar deficits for the now-foreseeable future.

We should show gratitude, nevertheless, that things could have been worse. Until the 2003 law passed, taxation of dividends was much more onerous when compared with taxes on capital gains. Not only were taxes imposed first on the corporation’s earnings and then again on the individual for the dividend earnings, the taxation was applied at the highest marginal rates for both. Consequently, $1 of pre-tax company earnings that might go toward paying a dividend would first get hit with a 35 percent corporate income tax, leaving just 65 cents from which to pay the dividend. Out of that amount, a 5 percent dividend would net just 3.02 percent to the shareowner after paying personal income taxes of 39.6 percent on the dividend.

Capital gains, by comparison, were taxed at 20 percent prior to that law, and were paid only by the shareowner, only on the increase in share value, and then only when the shareowner decided to sell or give away the shares. A 5 percent gain, should the investor choose to take it, would produce a 4 percent ultimate return to the shareowner, almost one-third greater than the net cash return from a dividend.

The 2003 cuts significantly closed the gap between the two rates by taxing them both at 15 percent. I say significantly reduced the gap because dividends remained taxable at the corporate level, first. But the elimination of the rate differential made the cash return to the shareowner equal for both.  The issue here is not how much individuals or corporations should or must pay in taxes. The issue is how tax policy affected company decisions prior to 2003, often to the detriment of shareowners, employees, and society at large.

Case in Point: WorldCom

For self-interested company executives, the different outcomes created by the different tax rates were a justification for strategies that discouraged dividends. A better course, they argued and adopted with the rubber stamp of complicit boards, was one to “reinvest” in mergers and acquisitions. That such a strategy provided direct benefits to those at the helm likely made such decisions a little easier.

A classic example was WorldCom. CEO Bernie Ebbers, like dozens of company chiefs, chose to invest in acquisitions for a couple of reasons. First, a merger would eliminate a current or potential competitor. Acquisitions also tended to show immediate increases in earnings and market capitalizations, as compared with the long, drawn-out drudgery of hit-or-miss product developments and innovations, thus providing immediate bumps in the companies’ share prices. The more acquisitions that were made, the more complicated it became for analysts to follow the accounting decisions company executives were making. Finally, the bigger the company, the bigger the gains in earnings and capitalization and the more complex the financial reporting, the more the executive team received in compensation, largely from stock option grants.

Prior to 2002, WorldCom had completed “no fewer than 65 mergers,” Kurt Eichenwald wrote in The New York Times. In early 2000, it was planning to buy Sprint Corp., as well, for $120 billion, before market realities intervened. Nevertheless, in the decade leading to the company’s collapse in 2002, Ebbers’ cash compensation rose quickly to $8.5 million in 1999 with control of more than 27 million shares in company stock worth around $1.5 billion, from around $800,000 and 7.3 million shares worth $142.1 million in 1992.

While most companies adopting acquisition strategies did not disintegrate due to fraud the way that WorldCom did, rarely did the deals the deals spawned produce the results promised, regardless of whether the companies were in telecom or some other line of business. America Online Inc.’s ill-fated $182 billion acquisition of Time Warner Inc. in 2000 is but one glaring example. Tom Brown at has tracked a depressing list of over-priced, poorly executed, and ill-advised mergers by some of the nation’s biggest banks over the past two decades. In nearly every case, the promised synergies, cost savings, or increases in shareowner value were long forgotten and even harder to track once the latest and best acquisitions were announced.

Special Dividends: Microsoft Then; The Washington Post Now

Soon after the 2003 tax law took effect, investors began noticing a difference. Microsoft Corp., for one, made headlines by deciding to pay a special $32 billion dividend and to implement a $30 billion buyback program as a means of paying out a large chunk of the $64 billion in cash it had accumulated over the prior decade to its shareowners. Other companies like Abbott Laboratories, Citigroup, and DuPont, among others with higher dividends, suddenly became attractive, again.

The dividends gave investors a choice of reinvesting in the stock of an issuing company, investing in startups like Google or Facebook, buying real estate, or consuming the cash, among a multitude of options. The decision was based on the specific needs of companies’ shareowners, rather than to the benefit of corporate insiders.

Fearing the worst, dozens of companies, including The Washington Post Co. — which editorialized in favor of taxing dividends at pre-2003 rates —declared special dividends in anticipation of significantly higher tax rates. Alas, the markets have largely dodged a bullet with the New Year’s bill: not only are taxes on dividends not reverting to pre-2003 levels, but the rate will remain level with those paid on capital gains.

Solving National Debt and QE Issues Still to Come

Sadly, this was the easy part for policymakers. Limiting tax increases for 98 percent of the population is something that even spend-happy politicians can support. Still, the higher rates the Internal Revenue Service will attempt to collect on the other 2 percent won’t cover even one-half of any deficit in the foreseeable future.

Solving the really big problem of financing all that spending with something other than borrowed and printed money looms large. Finding agreement on those issues will provide a truer test of policymakers’ mettle. That should quickly put a damper on the market’s enthusiasm.

Photo credit: ©

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

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