Stock Returns Imperiled by Pay-as-I-Say Obama: Kevin Hassett
Commentary by Kevin Hassett
April 12 (Bloomberg) -- While the nation was focusing on the health-care debate, Democrats passed a new budget rule that clearly signals their plan to increase taxes sharply this year. The awful details have gone largely unnoticed.
On Feb. 12, President Barack Obama signed into law pay-as- you-go budget rules. So-called paygo rules, which bar Congress from increasing spending unless it’s offset by budget cuts elsewhere, were in effect from 1990 until 2002, when they were allowed to expire. The goal of paygo, Obama said in his radio address to the nation on Feb. 13, is to ensure that “Congress will have to pay for what it spends, just like everybody else.”
Anyone looking at the current deficit or the health-care bill knows that the president’s commitment to spending restraint is half-hearted. This was evident in the paygo rule, as Democrats excluded the costs of many of the things they plan to do this year. One is their promise to extend, for households with incomes below $250,000, the expiring tax cuts enacted by President George W. Bush.
For investors, what matters most is that the paygo rule will make it difficult to pass anything that reduces the revenue that feeds Washington. So don’t count on an across-the-board extension of the dividend-tax deduction that Bush signed into law in 2003, slashing the top tax rate to 15 percent. Any such extension is likely to be limited, again, to those earning $250,000 or less.
This is a big break from Obama’s rhetoric.
Campaign Pledge
During the 2008 campaign, Obama promised that he would not lift the tax rate on dividends above 20 percent, for anybody, regardless of income. If Democrats intended to respect that promise, they would have said so in the paygo rule. The odds are high that the dividend tax is going up. Way up.
How far? Unless congressional Democrats decide that an Obama promise should appear to have some meaning, dividends will go back to being treated as ordinary income for those with incomes above $250,000. That means that those in the top bracket, people who hold the majority of dividends, will pay 39.6 percent tax.
The tax fun does not end there. The health-care legislation that fulfilled the dreams of so many Obama supporters slaps an extra 3.8 percent tax on investment income.
This dividend tax change is big news for markets. Equities, after all, have value in part because they pay dividends. Right now, a taxable investor in the U.S. should be willing to pay 85 cents for every expected dividend dollar. If taxes revert to pre-Bush levels -- and assuming some other changes, such as Obama limiting itemized deductions -- that drops to 55.4 cents.
Real Impact
While equities wouldn’t drop quite that much -- for reasons including the possibility that markets have already factored these changes in -- such a steep tax hike would have real effects.
That dividend taxes have an impact on value is by now well established. A study I co-wrote with a University of California at Berkeley economist, Alan Auerbach, found that firms that paid higher dividends saw share-price increases that significantly outpaced those paying lower ones.
In a follow-up study published in the American Economic Review, Auerbach and I found that markets anticipated movements in dividend taxes quite efficiently.
Specifically, we took advantage of data from the political futures markets that provided daily estimates of the probability, in 2004, that Bush would beat or lose to Democrat John Kerry, who intended to repeal the dividend tax cut. We found that share prices responded to changes in the odds of Bush winning in a manner consistent with our earlier results.
Higher Payouts
Low dividend taxes have also been shown, in a series of papers by economists Raj Chetty of Harvard University and Emmanuel Saez of the University of California at Berkeley, to increase dividend payouts.
And higher payouts are a good thing. In a high-dividend-tax world, cash piles up inside firms and creates opportunities for management to waste shareholder money. In a low-dividend-tax world, more cash goes to investors, which makes them more willing to invest.
The Chetty-Saez results suggest that dividends will drop sharply when the tax goes back up. A more immediate effect may be more important. Companies might choose to pay dividends this year instead of in the future, to take advantage of the still- low tax rate. If so, they might delay or cancel plans to use the money to invest in expanding their operations.
So right when we need job creation the most, Democrats are signaling to firms that they should mail the money back to investors instead.
Perhaps Obama the candidate kept his proposed dividend-tax increase modest because his economic advisers respected the research. One can only hope that they will now prevail on Obama the president.
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