My recent article about dividends (Attn: The Corner Office – Why U.S. Firms Should Pay Special Dividends Before Year-End 2010) encouraged companies to pay out cash dividends for three reasons: low tax rates on dividends, low borrowing rates, and the business attractions of going “lean.” Too much cash (and, as I noted, cash balances on business balance sheets are at high levels) tends to lead to that cash being wasted (the Jensen free cash flow hypothesis). However, much of the urgency of my advice, and its focus on December 31, 2010, was driven by the tax rises that seemed likely when I submitted the draft of the article on September 21. But, to paraphrase Mark Twain, rumors of the death of low dividend tax rates were exaggerated, and I was one of the people doing the exaggerating. With President Obama having reached a quick agreement with Congressional Republicans and having signed an extension of the dividend tax rates and other tax rates for two years on December 17, the window for paying dividends at low tax rates has been, at minimum, extended. As punditry then, I think the article is not the greatest. But as business advice, I believe it still stands.
Clearly, the results of the Congressional election on November 2 changed the political landscape on this issue in ways I did not anticipate. Although the results were broadly as expected for Democrats (i.e. they lost the House, but not the Senate), confronting the reality of them changed attitudes. Democrats’ appetite for a period of political gamesmanship (perhaps continuing their strategy of accusing Republican Congressmen of “holding the middle class hostage” in favor of tax cuts for those earning $250,000 plus) evaporated. For President Obama, tax rises hitting wage packets in January 2011 were a particularly unattractive prospect—the reality is that many voters do not even know who their Congressman is[1], and the President therefore faced the likelihood of being blamed for the tax rises, with resulting negative consequences for his approval ratings and re-election prospects. He moved quickly to eliminate uncertainty, at least in the short term, with the side effect of taking credit for extended tax breaks for all voters. Clearly, the “concerns that government live within its means” that I mentioned were completely ignored. For deficit hawks, it was “a stinker” in the words of Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget.[2] The result is a policy that is very positive for equity holders, but quite negative for debt holders, especially investors in nominal treasury bonds.
Which segues quite nicely into why I believe that those who took the advice to pay dividends in the near term have still made a good choice.
Borrowing rates to fund dividends are likely to rise: Because the agreement indicates a lack of concern for balancing government revenues with government spending (no spending cuts were packaged with the tax breaks), it is likely to lead to concern about U.S. government obligations, thus raising yields. Also, if the tax cuts have their desired effect of helping stimulate economic growth, they decrease the risks of deflation, which again has an upward effect on nominal yields.[3] In short, borrowing costs for businesses (which are heavily influenced by the biggest borrower, the U.S. Treasury) are likely to rise.
Cash is king, but too much cash makes managers behave like kings: Jensen’s free cash flow hypothesis is a sensible one. Managers with a lot of cash around as a safety cushion feel safer and less pressured to compete. Worse still, they are likely to waste the cash. The viewpoint held by some commentators that much of current cash piles are slated to be spent on acquisitions[4] should concern investors. Acquisitions are not, on average, profitable for investors in the company acquiring. Managers can gain a reputation for sound financial management by paying dividends and allowing investors to reallocate the money to lean businesses elsewhere.
Market uncertainty persists making stock buybacks not as attractive as they otherwise would be, as I discussed in the article.
The dividend tax rate rise has been postponed, but not repealed. The next crunch time is likely to be December 2012, when the current extension expires. If Republicans continue in the ascendancy, as they are now, dividend tax rates may remain low for some time after that. But political fortunes and public opinion may change before the two years are “up,” and (as former IMF Chief Economist Simon Johnson warns) there is also the potential threat of a fiscal crisis which may force tax rises across the board perhaps even sooner.[5] Until then, I would suggest that cash dividends (together with stock buybacks) remain a useful implement in the toolbox of business managers.
[1] In 1997, The Washington Post reported that 67 percent of voters could not name their Congressman. Quoted in Jeff Jacoby, “The ignorant American voter,” The Boston Globe, Oct 24, 2004.
[2] Maya McGuineas, “Tax plan: Get ready for a big debt hangover,” CNN Money, Dec 13, 2010 (http://money.cnn.com/2010/12/13/news/economy/maya_macguineas_tax_cut_deal/index.htm).
[3] Cordell Eddings and Susanne Walker, “Treasuries Fall Before Fed, Pushing 30-Year Bond Yield to Seven-Month High,” Bloomberg, Dec 14, 2010 (http://www.bloomberg.com/news/2010-12-14/treasuries-fall-before-retail-sales-report-yields-approach-six-month-high.html).
[4] Frank Aquila, “Conditions Are Ripe for an M&A Boom in 2011,” Bloomberg Businessweek, Dec 22, 2010 (http://www.businessweek.com/investor/content/dec2010/pi20101222_628902.htm).
[5] Simon Johnson, “Tax Cutters Set Up Tomorrow’s Fiscal Crisis,” Bloomberg Businessweek, Dec 23, 2010 (http://www.businessweek.com/news/2010-12-23/tax-cutters-set-up-tomorrow-s-fiscal-crisis-simon-johnson.html).
