The Tax Canard

Today’s cacophonous tax debate in Washington brings to mind this timeless chestnut from Mark Twain: “There are three kinds of lies: lies, damned lies and statistics.”

As the post-election jockeying over tax policy intensifies on Capitol Hill, it’s time to debunk media-perpetuated myths about taxes and how they affect investors. Many of the “statistics” you’re hearing about taxes on the cable TV news shows are specious at best.

First, there’s no evidence that a modest increase in tax rates always impedes stock market returns. The last time rates were raised significantly was 1993, and stocks followed the increase by staging one of their longest-lived and most dramatic bull markets in history.

Conversely, there’s no hard evidence that reducing tax rates always results in higher stock prices, at least over the long term. President Ronald Reagan’s 1981 tax cuts did precede a powerful run for stocks in the 1980s. But stocks were also underwater at the end of both of President George W. Bush’s two terms in office, despite lavishly generous tax cuts championed by his administration.

Don’t get me wrong. My point is not to advocate higher or lower taxes. Rather, it’s to explain an empirical truth: Tax rates represent only one factor among many that determine how stocks perform and the degree of wealth they build for investors. In fact, they’re not even close to being the most important factor.

No one enjoys paying taxes—no one in their right mind, anyway. If I had my druthers, rates would remain lower rather than higher, particularly when it comes to levies on dividends. And if you feel as I do, please sign this petition to keep dividend taxes low.

But neither does it make any sense to abandon positions in good stocks, just because investment tax rates are likely to go up next year. Nor does it make sense to buy a stock just because it’s speeding up dividend payments into 2012, so investors can avoid a higher tax rate. Juggling dividend timing should be considered a possible bonus, not sufficient reason for buying.

One illustrative example is IDT Communications (NYSE: IDT), which last month announced with great fanfare that it was paying a “special” dividend of 60 cents per share on or about November 13 for shareholders of record November 5. The implication was that the company was paying its “regular” 15 cents per share dividend in advance to reduce investors’ tax rates.

In reality, the payout was return of capital for a company that’s struggled for years to turn a profit in the fiercely competitive pre-paid phone business. And with that sector now rapidly consolidating, there’s considerable doubt this company will continue to generate anything approaching enough cash flow to pay a regular dividend in the future.

In contrast, Wal-Mart (NYSE: WMT) isn’t eliminating its dividend entirely next year. But the company is speeding up its fourth-quarter payout by a couple of days to December 27 to qualify for 2012 tax rates. Of course, the primary beneficiary will be the Walton family, which continues to own 47.9 percent of the stock through Walton Enterprises.

The Walton family would definitely suffer a big tax hit on fourth-quarter dividends paid, if Washington allows the economy to plunge off the “fiscal cliff” and rates revert to Clinton-era levels. However, that’s not a position shared by the vast majority of investors, or the institutions and individuals owning the stock through retirement accounts who will see no change in dividend tax rates.

Whether or not this move really benefits anyone besides the Waltons and a handful of others will depend far more on how Wal-Mart performs in the future as a business. Indeed, serious questions exist about the near-term benefit, because the stock has been in a downtrend since mid-October. The same dynamic applies to every other dividend-paying stock.

A Paucity of Income Choices

As for abandoning positions in good dividend-paying stocks because of prospective tax rate increases, those that do so will be quickly confronted with a stark question: What are your alternatives for generating income?

Certainly bonds are no alternative given their much lower rates, sensitivity to future interest rate increases and the fact that payouts are fixed. Funds that pay high yields only do so because they employ massive leverage, which would definitely come back to haunt them if interest rates rise in coming months as many fear.

In any case, with the exception of federally tax-free municipal bonds, bonds are fully taxed at ordinary income rates. The same is true of money market funds, savings accounts and virtually every other fixed income alternative.

Assuming no changes to the tax code that relate to them, asset-focused partnerships are a possibility for earning tax-advantaged income. They’ll likely get a lot more popular with high-bracket investors if rates are increased dramatically. Most, however, require investors to tie up their cash for a substantial period of time—and that’s no alternative for those who need cash now.

In short, no income alternative offers the breadth of diversification, ease of buying and selling and upside of dividend-paying stocks. That’s true regardless of the tax rate on dividends or, for that matter, capital gains.

Other investments are fine for balance—for example, high-quality bonds offer protection against a possible recession if lawmakers can’t avert the fiscal cliff. But no portfolio will grow and meet the challenges of coming years without a solid portion of well-chosen dividend-paying stocks, preferably loaded with companies that regularly increase dividends. It’s been impossible to live off your investments without stocks the past decade and it will be equally impossible the next ten years.

Sooner or later, the money that’s fled the market for fear of higher taxes will have to come back. The good news is that tax policy probably won’t pan out nearly as punitively as many investors now fear, so the rates they pay when they do return will hardly amount to expropriation.

The stakes for both political parties of not forging a federal budget deal before January 1 are almost too frightening to contemplate—especially for politicians who would face the wrath of voters. And a deal is only possible through compromise.

A prospective maximum dividend and capital gains tax rate of 20 percent to 25 percent is already under debate on Capitol Hill. Keep in mind, that’s a rate change that won’t touch institutions, retirement accounts nor investors who aren’t in the top 2 percent of earners.

Some may still want to run for the hills until a deal is signed, sealed and delivered. But higher taxes or no, the key to building wealth in stocks is the same as it ever was: the ability of the underlying businesses to profitably grow. As lawmakers horse trade and we wait for the political end game, that’s where our focus will stay.

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   Reply Steven Rose November 23, 2012 at 5:03 PM EDT

   In 1993 the tax increase was accompanied by some deregulatios and in Bush years we got more regulations.