In 29 days, Americans and small businesses face one of the largest tax hikes in American history.  As this impending tax hike draws closer, we here at the Campaign for Free Enterprise want to continue to educate you on exactly what this means for you and your business.  Here’s a link to our first post reminding you how we got here, what we really are facing, and why we must act now.  And here’s a link to our second post on what these impending tax hikes really mean for small businesses.  And here’s a link to our third post, discussing in detail what is going to happen to capital gains tax rates and how detrimental it is to investment and getting our economy on the road to recovery.

And here’s our fourth post – discussing in detail what is going to happen to dividend tax rates, who this really impacts, and how detrimental it is to investment and getting our economy on the road to recovery.  Look for additional posts in the coming days on the impact of these tax hikes.

FAQ: What happens to dividend tax rates if Congress does not act?

Answer:  If Congress does not act,

• In 2011, taxes on dividend income will skyrocket, rising from 15% to as much as 39.6%, an increase of as much as 164%.
• In 2013, the Medicare HI tax will kick in, adding another 3.8% tax to dividends, and bringing the tax rate on dividends as high as 43.4%. This is an increase of as much as 189% from the 2010 rate of 15%.

FAQ: Who benefits from reduced dividend rates?

Answer:  Millions of Americans – of all income levels – benefit from reduced dividend tax rates.

• According to the IRS Statistics of Income, in 2008, 26.2 million tax returns reported $144.8 billion of qualified dividend income.
  • Taxpayers with AGI of less than $100,000 accounted for 66% of those returns.
  • Taxpayers with AGI of less than $50,000 accounted for 37% of those returns.
  • According to the IRS Statistics of Income, since the reduced dividend rates have been in effect (for tax years 2003, 2004, 2005, 2006, and 2007), an average of 25.6 million tax returns have reported an average of $124.7 billion in qualified dividend income.
    • For these years, taxpayers with AGI of less than $100,000 accounted for an average of 70% of those returns.
    • For these years, taxpayers with AGI of less than $50,000 accounted for an average of 40% of those returns.

FAQ: Would any one group be disproportionately hurt by increased dividend rates?

Answer:  According to the nonpartisan Tax Foundation, which cites IRS Statistics of Income data, older Americans rely on dividend income.

• For 2008, of returns filed by taxpayers age 65 and older, 42% reported dividend income. Of all dividend income earned, 48% was earned by taxpayers age 65 and older.
• For 2008, 71% of all dividend income earned was earned by taxpayers age 55 and older.

FAQ: Would increased dividend rates adversely affect companies who pay dividends and shareholders who receive dividends?

Answer: According to the bipartisan Tax Foundation, raising dividend tax rates will disadvantage the largest dividend-paying companies and could reduce the level of dividend paid to shareholders.

• A September 2010 J.P. Morgan study concludes that in light of the significant uncertainty surrounding the dividend and capital gains tax rates next year, senior decision-makers should evaluate the corporate finance implications of potential distribution tax increases.  While taxes are not necessarily the key driver of financial policy, they could affect hurdle rates, valuation, capital allocation, leverage, and shareholder distribution decisions.
  • The extent to which firms are affected by changes in the dividend tax rate depends on the composition of their shareholder base. Specifically, firms with a high portion of tax-sensitive retail investors are more likely to be affected.  We find that retail investors tend to invest in larger firms, with stronger brands, lower leverage and higher dividend yield.
  • On the other hand, high dividend sectors that did not benefit from the current 15% dividend tax rate (e.g., REITs and MLPs) may benefit from the dividend tax increase on a relative basis.
  • Raising taxes on dividend income would create a disadvantage for dividend-paying companies and may cause companies to alter their current dividend strategies.
    • This could lower the amount of dollars by which companies ordinarily increase their dividends and could reduce the stock value for all shareholders.
    • If this happens, all taxpayers who receive dividend income would be affected, regardless of their income level, by discouraging investment in dividend-paying companies and potentially lowering dividend payouts.

FAQ: Would increased dividend rates increase economic instability?

Answer: Increased dividend rates will incentivize companies to use excessive debt financing.

• A September 2010 J.P. Morgan study concludes that an increase in the dividend tax rate would lead to a higher pre-tax cost of equity. As a result, equity valuation might be under pressure, corporations may reduce their investing due to higher hurdle rates, and debt might become more attractive relative to equity. Further, the study notes that higher dividend taxation relative to long-term capital gains further accentuates the existing tax benefit of share repurchases relative to dividends, making buybacks more attractive for some firms.
• Increasing tax rates on dividends can make investing in stocks less attractive to investors and can reduce a stock’s perceived value.  This decrease in perceived value coupled with the fact that interest on debt is a deductible corporate expense could cause companies to opt to finance new investments through debt offerings rather than stock issuances.
• As a result of this increased incentive to use debt financing, businesses may significantly increase debt levels as they attempt to optimize capital allocation.  These increased debt levels could cause greater instability in the economy and increase risk of failure.