Susan Dziubinski: Hi, I’m Susan Dziubinski from Morningstar. It is very likely that the corporate tax rate will be raised to fund the Biden government’s spending priorities. David Harrell joins me today to discuss what a higher corporate tax rate could mean on dividends. David is the Editorial Director at Morningstar Investment Management and the manager of Morningstar Dividend Investor. Hello David. Thank you for being here today.
David Harrell: Thanks for the invitation.
Dziubinski: In a recent issue of Morningstar Dividend Investor, you examined US corporate tax rates for larger companies that pay dividends over time. What have you found?
Harrell: As you know, corporate tax rates in the US have been falling since the 1950s when they rose by over 50%. Unfortunately, we don’t have a good up-to-date example of what happened to dividends following a corporate tax hike. But we have an example of what happened from 2018 after corporate rates fell from 35% to 21%.
Dziubinski: And what happened there?
Harrell: Well, U.S. firms continued to increase their dividends in 2018 and 2019. It appears, however, that all of the dollars US firms saved through a lower corporate tax rate were far more likely to have been used to buy back or buy back their own stocks than to be funnel-shaped for dividends.
Dziubinski: Are the dividend increases we’ve seen in 2018 and 2019 how they compare to other periods of dividend increases?
Harrell: They were completely in line with what we saw in the six calendar years prior to this tax cut, when the corporate tax rate, the statutory tax rate, was 35% in the United States.
Dziubinski: So if lowering the corporate tax rate didn’t really increase dividends, can we extrapolate that increasing the corporate tax rate won’t affect dividends either?
Harrell: There is no way of knowing for sure. This is like one of those situations where I wish there were parallel universes that we could look into and see, well, this one had a tax cut and this one didn’t, and what happened to the dividend rates. I’m not worried about dividends themselves. As you know, Morningstar analysts have a probability-weighted expectation in probability-weighted expectation that US corporate rates will rise from 21% to 26%. Well, the worst-case scenario we’re currently looking at with the Biden administration’s proposal is going down from 35% to 21% as of 2018, and they basically want to split the difference and up the rate again. increase 28%. That is the worst case scenario.
It should be noted, however, that Morningstar analysts found that with this 14 percentage point drop in the statutory tax rate, taxes actually halved the effective tax rates for U.S. companies because not all firms paid the statutory maximum . I therefore think it is likely that if the tax rate is increased by, for example, 5, 6 or even 7 percentage points, the effective tax rate for US companies is more likely to increase by 2, 3, 4 percentage points.
And of course what happens there is all the same, if a company has less after-tax cash, there are fewer dollars to fund the dividend. I think it’s unlikely that a company would say we’re cutting our dividend because of it. But if you had a company that had a 60% payout rate, for example, and the tax hike would cause the payout rate to go up a few percentage points, say, 63%, and you want to stay stable. What you could see , is perhaps a slowdown in future dividend growth, and it wouldn’t take much over several years to keep that payout ratio the same.
But I think it’s probably more likely that companies, because they used those extra dollars to use money on buybacks rather than dividends, I think if their rate goes up again, it’s more likely that there will be fewer buybacks . And again in the worst case scenario, we are looking at a corporate tax rate of 28%, which is 7 percentage points below the 35% rate that applied from 1993 to 2017. And that was still a time when we had, at least overall, very healthy dividend growth for US stocks.
Dziubinski: Finally, of course, there is a chance that even if we do see a corporate tax hike, it might not be that long-lasting, right?
Harrell: That’s correct. The only reason this is possible right now is because you have a Democratic President, a House of Representatives, and, very narrowly, a Democratic Senate. So we have to consider what is likely to happen in the next election cycles. If it starts in 2024, well, 2025 after the inauguration, or 2029 when party control is flipped. You can see very well that when the tax rates go up to, say, 26 or 28%, they go back down to the 21% where they are now.
Dziubinski: Well, David, thank you for taking the time today to put the potential corporate tax hikes for dividend investors in perspective. We appreciate it.
Harrell: Thanks for the invitation.
Dziubinski: I’m Susan Dziubinski from Morningstar. Thanks for switching on.