Highly Taxed Stocks Get Higher Returns
Stocks facing higher effective tax rates tend to compensate taxable investors by generating higher before-tax returns.
ANN ARBOR, Mich.—Investors who own stocks with higher tax rates also get higher returns, says a University of Michigan finance professor.
Using new data covering tax burdens on a cross-section of equity securities between 1927 and 2004, Clemens Sialm of U-M's Ross School of Business found a strong link between risk-adjusted stock returns and effective personal tax rates (total tax paid divided by net taxable income before taxes).
Specifically, a one percentage point increase in the effective tax of an equity portfolio increases the average return of the portfolio by 1.54 percentage points.
"Consistent with tax capitalization, stocks facing higher effective tax rates tend to compensate taxable investors by generating higher before-tax returns," Sialm said. "The average returns of highly taxed securities tend to be high because their valuation levels are relatively low. Thus, taxes tend to depress asset valuations, resulting in higher average before-tax returns."
Sialm's study shows that effective tax burdens have varied significantly over time. For example, the rates on the market portfolio of common stocks exceeded 25 percent in 1950, but dropped to less than 5 percent in 2004.
"The aggregate tax burden on equity securities has declined over the last couple of decades as tax reforms reduced the statutory tax rates on dividends and capital gains," Sialm said. "Furthermore, corporations replaced a significant fraction of relatively highly taxed dividends with share repurchases."
According to Sialm, stocks that distribute a greater proportion of their total returns as dividends tend to be taxed more heavily than stocks that distribute a smaller fraction of dividends. Dividend-paying stocks face, on average, an effective tax rate nearly three times higher than the effective tax rate of stocks that do not pay dividends.
However, these highly taxed, dividend-paying securities tend to pay significantly higher returns. The average return spread between high-dividend and no-dividend stocks is 4.55 percent, while the spread is 3.63 percent between all stocks that pay dividends and those that do not.
Sialm says that although dividends are highly correlated with the effective tax rate, it is the latter and not the former that is the driving force behind the higher expected returns.
"Stocks paying high dividend yields tend to have relatively high risk-adjusted returns, particularly in periods when taxes are high," Sialm said. "This result indicates that the reported effects are likely due to taxes and not due to the fact that dividend yields might proxy for additional risk or style effects."
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