Companies and investors are waking
up to dividends-but will it last?

    Corporate dividends generally went the way of the dodo bird in the booming 1990s. Almost, but not quite. All but forgotten and shunned by corporations in favor of stock buybacks-which increase earnings per share-dividends today are making a strong comeback, thanks partly to a tax cut that slashed tax rates on dividends by more than 50% for affluent investors. Over the next ten years, as millions of baby boomers age and retire, dividends and tax efficiency are expected to play major roles in income-seeking investors' portfolios.
    At a recent conference in New York City, sponsored by Boston-based investment firm Eaton Vance Corp., known for its tax-efficient mutual funds, the focus was on dividends, taxes and public policy issues, and their effects on the capital markets and investors. The conference was held to highlight results of an Eaton Vance survey that found senior finance executives at dividend-paying companies overwhelmingly in favor of extending President Bush's tax cuts beyond 2008, when they're set to expire.
    Congress is currently debating the issue. Findings of the firm's seventh annual investor survey show similar support among individual investors, with seven of ten in favor of extending the cuts. But the surveys also pointed out that many investors remain confused about how to invest for tax efficiency, and retain unrealistic expectations about potential capital gains distributions.
    As an illustration of such large distributions, fund tracker Lipper Inc. found that $124 billion of long-term capital gains were distributed by open-end equity mutual funds in 2005. This amounted to 168% more than 2004's distributions, and was comparable to distributions in 1998, which was the third-highest level ever of distributions from open-end equity funds.


A New Era Of Investing
    "The dynamic still exists for unnecessarily large distributions. Investors would be well advised to protect themselves from unnecessary taxes by holding high turnover equity funds in their retirement accounts and seeking tax-managed funds to hold in taxable accounts," urged Duncan W.              Richardson, executive vice president and chief equity investment officer of Eaton Vance Management.
    Richardson, who moderated the panel discussion, opened the meeting with a reference to Graham and Dodd's classic book, "Security Analysis," published in 1934: "The prime purpose of a business corporation is to pay dividends to its owners. A successful company is one which can pay dividends regularly and presumably increase the rate as time goes on."
    A confluence of events has raised the profile of dividends as a use of corporate cash, he said. One was passage of the Sarbanes-Oxley Act in 2002, which mandated greater board oversight and more transparent financials. The second was passage of the Jobs & Growth Tax Relief Reconciliation Act of 2003, which put dividends on tax parity with long-term capital gains. The third factor has been a fairly robust economy and accumulation of excess cash reserves by many U.S. companies, which gives them the means to pay out more dividends. The final element is the existence of large pools of private equity funds that have been active. "If management can't find productive uses for the cash in those funds, someone else will," Richardson warned.
    "Both the survey results and recent changes in corporate behavior may indicate we're coming into a golden era of equity income investing," the executive said.

Dividends Past, Present And Future
    Panelists included Alice M. Rivlin, a visiting professor at the Public Policy Institute of Georgetown University and a senior fellow in the economics studies program at the Brookings Institution; Tom Roseen, a senior research analyst at Lipper; Howard Silverblatt, senior index strategist at Standard & Poor's; and Mark A. Weinberger, former U.S. Assistant Secretary of Treasury for Tax Policy and current vice chairman of Ernst & Young LLP, overseeing the Americas tax practice.
    "The era of disrespect to dividends may be coming to an end," Rivlin declared. Companies neglected paying dividends during the roaring stock market in the 1990s, concentrating instead on accumulating capital gains. Another reason companies have shied away has been the double taxation standard on qualifying dividends-once at the corporate level and again at the individual level.
    But the huge numbers of baby boomers about to retire and in need of income-producing investments, coupled with the reduction of the maximum tax rate for qualifying dividends to 15% in the 2003 tax act, augur well for more dividend payouts, she said.
    Moving on to public policy issues, the former vice chair of the Federal Reserve cited the need for sweeping improvements in the federal tax system and reducing federal budget deficits. "We're facing huge federal deficits that are almost certain to grow as promises to the elderly come due, and we can't borrow our way out of the problem," Rivlin said. "We're going to have to do three things at once: We have to scale back those promises to the elderly, we have to reduce other federal spending, and we have to raise more revenue.
    "While the lower rate (on capital gains) may well have beneficial effects on corporate behavior (higher dividend payouts, less cash accumulation, higher corporate returns), the cost to the Treasury in lost revenue makes the looming deficits worse. The critical dilemma should be seen as an opportunity to get our tax system right. It would be far preferable, albeit more daunting, to push through reform and simplification of the income tax. We need to broaden the tax base so that all tax rates can be lower, and ensure that return on capital is taxed only once and not at rates that discourage investment. But we need to do this without exacerbating the widening gap in after-tax income between average people and the superrich."
    In his remarks, Roseen focused on tax issues as they impact investors in mutual funds and the funds themselves. Over the last ten years, taxable fund investors have surrendered between 1.6 and 2.4 percentage points each year to taxes, Roseen said. That equates to one to three times the amount of funds' expense ratios over that period.
    "Taxes matter," Roseen said. "The investor loses over four times the initial investment to Uncle Sam." To illustrate his point, he noted that if an investor had invested $10,000 over a 30-year period, the wealth at the end of the period would have grown to $113,053, or 8.2%, without taxes. With taxes, however, the total return would have dropped to $72,170, representing a loss of $40,883, equal to 1.62% compounded annually.
    Lipper survey figures show that 55% of domestic fund flows went into value-oriented or dividend-paying types of funds in 2003. That increased to 73% in 2004, and to a startling 168% in 2005, a relatively bad year for funds, meaning that overall investors have more of a "pay me now attitude," Roseen said.
    Roseen also provided examples of how much rising dividend income and the changes in tax rates on qualified income have helped fund investors in recent years. For example, in 2004, funds in Lipper's U.S. Diversified Equity (USDE) funds macro-classification distributed $12.9 billion more in dividend income than in 2002, but investors paid almost the same amount in taxes as they did in 2002. In 2002, USDE funds distributed an estimated $13.6 billion in dividend income and investors paid an estimated $1.3 billion in taxes, whereas in 2004 such funds distributed $26.5 billion in dividend income and investors paid an estimated $1.3 billion in associated taxes.
    Silverblatt provided data that suggested that the 2003 tax act has contributed to positive changes in corporate dividend behavior. The number of S&P 500 stocks paying dividends over the past 25 years fell from a high of 469 to a low of 351 in 2002, a fall from almost 94% to just over 70%. Currently, 387 of the S&P 500 companies pay a dividend, he noted. That's only 71%, well below the previous high of dividend payers, he noted. The implication is that more companies would probably follow suit if favorable treatment of dividends is extended or made permanent by Congress.
    He also pointed out that since the changes in the 2003 tax act, there have been 976 dividend increases in total by companies, as opposed to 36 suspensions, nearly a 27 to 1 ratio.
    Weinberger said the 2003 tax act was a first step in ameliorating some of the bias in the tax code against capital formation, and specifically the double taxation of corporate dividends. The effect was to raise after-tax returns on capital and equalize the tax treatment of dividends and capital gains. But the changes didn't go far enough, and the double taxation of capital income should be eliminated, according to Weinberger.
    Weinberger stressed that future dividend tax rates matter to investor decisions being made today. "When investors are deciding in 2006 in which company stock or mutual fund to invest, they are looking at the future after-tax returns," Weinberger said. If dividend and capital gains tax rates go back to the top rate of 35% beyond 2008, and 39.6% beyond 2010 (lower individual tax rate expires in 2010), investors and corporations will be inclined to return to favoring share repurchases and debt financing.
    He said the United States needs to make other changes to the tax code so it is on a more level playing field with the tax systems of its major trading partners. He noted most major trading partners provide some form of relief from the double standard in the U.S. Regarding the current Congressional debate about extending the lower rate on capital gains and dividends, Weinberger predicted that the lower 15% rate would be extended for at least one year, through 2009.


Bruce W. Fraser, principal of Bruce W. Fraser Communications in New York, has written for many publications. He may be reached [email protected] or www.bwfraser.com/home.