In 2003, Congress unified the tax rates for dividends and capital gains at 15%, but the sunset provision in the law causes it to expire at the end of this year. If Congress decides not to extend its provisions, the maximum tax rate for dividends will rise in 2011 to 39.6% from 15%, while that for capital gains will rise to 20% from 15%.
The Obama Administration is inclined to align tax rates on both dividends and capital gains at 20%. Congress has yet to enact his proposal, however.
What does this situation mean for investors? Should they reduce exposure to higher-yielding sectors such as utilities, where dividends have historically comprised over two thirds of long run shareholder returns?
To answer these questions, Hugh Wynne, senior analyst with Bernstein Research, reviewed the performance of utility stocks around prior tax-rate changes in a report released April 23.
He came to the following conclusions:
- After tax law changes that reduced the rate of taxation on dividends relative to capital gains, such as those of 1986 and 2003, utilities outperformed the broader market over both one and three year investment horizons.
- Following tax law changes that increased the rate of taxation on dividends relative to capital gains, such as that of 1993, utilities underperformed the broader market over one and three year periods.