the dividend cliff

Last week, NYU Stern professor Aswath Damodaran wrote a blog post on the coming fiscal cliff and the impact it could have on dividend stocks in particular. Later in this article, I'll get more specific about which stocks are most likely to see effects from higher taxes on dividend stocks, but first, let's take a closer look at Professor Damodaran's argument.

The crisis we're facing now is a direct result of the way in which tax cuts were structured over the past decade. In 2001 and 2003, new tax laws reduced rates on ordinary income, dividends, and capital gains substantially, with one of the biggest benefits being given to dividends. For most stocks, dividends had their maximum tax rate reduced to 15% -- a big savings over prior law's treatment of dividends as ordinary income potentially subject to much higher marginal tax rates for high-income taxpayers.

With these tax laws, though, was a catch: They would expire in 10 years. After a two-year extension back in 2010, these cuts are now once again slated to go away at the beginning of 2013, and the coming election gives politicians little incentive to do anything about the looming deadline until after the first week of November.

Damodaran does a good job of explaining what impact higher dividend taxes should have on rational investors. Essentially, he argues that investors value stocks based on their after-tax dividend yield. So if taxes on dividends rise, investors will demand a higher pre-tax dividend yield in order to end up with the same amount of income after taxes.

To show his work, Damodaran goes through a concrete example in valuing the S&P 500 under a change in tax laws. Based on his latest observations, he believes the S&P 500 could be vulnerable to a roughly 15% drop from current levels based solely on dividend taxes.