Tax Hikes, Low Inflation Set Up Catch-22 For Dividend Investors

Thursday, 19 Jul 2012 04:54 PM

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Investors who like the safety and predictability of dividend-paying stocks, which are popular amid times of low interest rates and a lackluster economy, are staring a massive Catch-22 right in the face.

At the end of the year, Bush-era tax breaks expire and other taxes are set to rise, including those on investment income, which includes money earned from dividends.

Furthermore, inflation is set to remain weak, and Federal Reserve officials have said conditions meriting rock-bottom interest rates are due to stick around through 2014, which would make dividend-paying stocks attractive.

So what's an investors to do? Stick with dividend stocks and pay higher taxes next year or invest in government debt and earn dismal interest rates that won't even keep pace with tame inflation rates?

"For investors, this creates something of a Catch-22," according to U.S. News & World Report.

"On the one hand, with the expiration of the Bush tax cuts in 2013, the top tax rate on dividend income could soar to 39.6 percent. In other words, dividends would be taxed as ordinary income," the magazine reported.
Dividend income is currently taxed at 15 percent.

"At the same time, dividends have long been a safe haven when fears of slow growth and deflation loom on the horizon. That is because their steady stream of income has traditionally provided a much-needed buffer in times of economic malaise."

Be patient, for now, seems to be sage advice..

Lawmakers from both sides of the aisle have called for extending the Bush tax cuts, and nobody knows what's going to happen between now and Dec. 31, when the tax breaks do expire.

Inflation rates, meanwhile, are not likely going to spike anytime soon.
Federal Chairman Ben Bernanke said so himself recently.

"I think inflation risk is relatively low now. Not everyone agrees with that, but my personal opinion is that that risk is reasonably low right now," Bernanke told the Senate Banking Committee in a recent testimony, U.S. News & World Report added.

"And indeed ... there is a modest risk—not a large risk, but a modest risk—of going in the other direction, which is towards the deflationary side."

Further complications lie ahead as well.

President Barack Obama's Patient Protection and Affordable Care Act calls for tax rates on capital gains and dividends to jump from their current 15 percent level to 18.8 percent to help fund overhaul of the healthcare sector, the Wall Street Journal reported recently.

That's separate from the Bush tax cuts.

Despite the support for extending the Bush-era tax cuts, disagreements have arisen even within the parties themselves as to how those cuts should be extended and by how much, for how long and for whom.

"The bottom line is that nobody can predict with any certainty what will happen to rates. Right now, the only thing that's entirely clear is that passions will run high," U.S. News & World Report concluded. "Election-year politics and tax debates have traditionally been explosive bedfellows, and this cycle has been no exception."

The Bush tax cuts expire right at the same time automatic cuts to government spending kick in.

The combination of tax hikes and cuts to government spending, known as a fiscal cliff, could siphon as much as $500 billion out of the economy next year alone and send the country sliding right back into recession.

One thing that is clear, experts say, is that Congress must act now to prevent the sharp fiscal adjustment from becoming a reality to ensure better days lie ahead.

The tax hikes and spending cuts that trigger in January of 2013 constitute more than 4.5 percent of gross domestic product, which an economy growing at 2 percent cannot withstand, Moody's Analytics chief economist Mark Zandi said in his latest monthly outlook.

"The U.S. economy is growing, but uncomfortably slowly. Real GDP is expanding at an annual rate of only 2 percent, and recent payroll job gains have averaged 75,000 per month. At this pace, unemployment will remain stuck above 8 percent for some time," Zandi said.

The unemployment rate stands at 8.2 percent today, well above pre-recession levels, and the country could see rates below 6 percent in just three years but only if Congress adjusts fiscal imbalances.

"Still, despite the difficulties, the U.S. economy can indeed rebound," Zandi said.

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