High dividend taxes hurt the nation

President Barack Obama's proposed 2013 budget should be worrisome to all investors, especially those who rely on dividend-paying stocks for a substantial portion of their income, such as retirees.

If he has his way, dividends paid to “high-income Americans” — that is, individuals who make $200,000 a year or $250,000 a year for a couple — would be taxed as ordinary income, boosting the top rate paid to 39.6%, from 15%. Add in the 3.8% investment tax surcharge in the Obama administration's health care law, and the dividend rate would top out at 43.4%.

Never mind that the dividend payments already are taxed twice: first, when companies pay taxes on earnings from which the dividends are derived and, second, when individual shareholders pay income taxes on their dividend earnings.

Theoretically, the change in dividend taxation would raise $206.4 billion over a decade, according to the White House, which is justifying the Draconian proposal by saying that the nation simply can no longer afford to continue taxing dividends at a more favorable rate.

The real question, however, is whether the nation can afford not to.

HARMFUL EFFECTS

High dividend tax rates are detrimental in many ways.

For starters, raising the dividend tax rate would end the parity that exists between the tax rate on capital gains and dividends. Taxing dividends at a significantly higher rate would artificially affect how companies return value to shareholders by encouraging them to favor capital gains over dividend payments.

As a result, companies would more likely focus on stock appreciation to return shareholder value. That is bad for stockholders, as it tends to encourage profligate spending by corporate executives.

Raising dividend taxes also would cause companies to rely too much on debt financing, as opposed to equity financing.

The payments on debt are before earnings and receive a tax deduction as a business expense. Conversely, dividend payments aren't tax-deductible.

Do we really want to begin encouraging companies to load up on debt again?

Finally, higher taxes on dividends would hurt retirees more than pre-retirees. Retirees are far more likely to own stocks that pay dividends than other demographic groups, especially now, in an environment where yield is almost impossible to find in certificates of deposit, Treasuries or money market funds.

Of the roughly 140 million tax returns filed in 2009, 25.4 million reported nearly $123.6 billion in dividend income qualifying for the 15% tax rate. Although 18% of all returns reported dividend income, 32.5% of taxpayers over 65 reported dividend income, according to Internal Revenue Service data.

Overall, taxpayers over 65 accounted for 51.3% of all dividend income earned in 2009, and that dividend income accounted for nearly 6% of all the income earned by these taxpayers, the IRS data showed.

Of course, the harmful effects of higher dividend taxes would extend beyond seniors.

All Americans would suffer. The dividend tax hike, coupled with Mr. Obama's proposal to tax long-term capital gains at a top rate of 20%, from 15%, would likely trigger a huge sell-off in the market, at least, initially.

THREAT TO STOCK VALUES

Indeed, raising the two rates would reduce the value of stocks to investors. Seeing those hikes coming, many investors would dump their stocks, driving stock prices down and encouraging other investors to run for the exits.

To be sure, there are no easy solutions for reducing this country's budget deficit. But any reasonable solution likely will include a major renovation of the tax system, the likes of which have not been seen since the Tax Reform Act of 1986.

It also would have to include a serious effort to close major loopholes, such as the “carried interest” loophole, which allows hedge fund managers to have their bonuses taxed at the long-term capital gains rate, rather than at the ordinary- income rate.

But no matter how you cut it, it is better for the stock market and the economy if more companies pay dividends.

Without a doubt, a company's decision to pay dividends for the first time or to increase its dividends is a sign of its confidence in the future.

And confidence in the future is exactly what investors need right now.