What They Don’t Want You to Know About the New Tax Plan

Marc Lichtenfeld By Marc Lichtenfeld
Chief Income Strategist, The Oxford Club

Retirement Planning

President Trump’s new tax plan aims to lower taxes for most Americans. Whether it does so remains to be seen. While tax rates will be reduced and the standard deduction will double, the elimination of other deductions – including the ones for state and local taxes – will offset some or all of the savings.

Another important part of the plan is that tax rate paid to corporations will be reduced to 20% from 35%. This will make the U.S. a more desirable location to do business, creating jobs and sparking investments in the process.

Thanks to lower corporate tax rates, many pundits expect companies to return more capital to shareholders via dividends and share buybacks. The thinking is that if the companies have more net income (after taxes), they can afford to boost dividends.

That’s not going to happen. Here’s why…

  1. The earnings boost might not be as big as you think.

In addition to benefiting from a lower tax rate, companies will now be allowed to write off capital expenditures (capex) as an expense on the income statement. Previously, they were not able to do that.

For those of you who fell asleep in accounting class, this is important.

Currently, if a company spends money on items that are classified as capex, such as new factory equipment, it’s not counted in the calculation of earnings.

Let’s set up a simple example. Let’s say a company generated $100 in revenue, had $50 in costs of goods sold and had $20 in sales, general and administrative expenses. Then, if it spent $10 on capex and paid a 20% tax, its income statement would look like this…

Notice that the capex is not listed on the income statement.

Under the new plan, this would be the new income statement…

You can see that the company’s profits fell by $8 because the capex is now factored into the profit formula.
So the lower tax rate should add to profits, but companies that spend a lot on capex will offset some – or all – of that benefit.

  1. Lower earnings could mean lower dividends.

Even if profits go down as a result of expensing capex, cash flow will not. That’s because capex is currently accounted for in the statement of cash flows. Today, capex reduces free cash flow. Tomorrow, it will reduce net income, which is used to calculate free cash flow. So capex is being factored into cash flow no matter which financial statement it’s on.

If you know me at all, you know I’m all about cash flow. It’s what I use to determine a company’s ability to pay dividends, calculate dividend safety in Safety Net and calculate a company’s payout ratio. I use cash flow instead of earnings.

So why do I think dividends could go down if cash flow will remain relatively the same?

If a company’s earnings do not increase, the company may use it as a reason to not pay or raise a dividend.

Companies typically use earnings as a barometer for paying dividends. Many base their dividends on a payout ratio that is measured using earnings, not using cash flow as I do.

For example, a company may have a stated payout ratio goal of 75% of earnings. So if it earned $100 million, it would pay out $75 million. If cash flow was $120 million, the company would still pay only $75 million because it’s using earnings, not cash flow, to calculate the payout ratio.

Some management teams don’t like to return much capital to shareholders. This way they can keep more cash on hand to make boneheaded and expensive acquisitions that achieve short-term goals or trigger bonuses, rather than reward investors.

Here’s What You Can Do About It

If you’re concerned about how the new tax policies and accounting changes will affect your dividend payouts, look for Perpetual Dividend Raisers – companies that have raised the dividend every year for five years or more, preferably 10.

Management teams of Perpetual Dividend Raisers have proven that they are committed to rewarding shareholders each year.

Not only that, but these companies have seen a thing or two.

For example, Lowe’s Companies (NYSE: LOW) has raised its dividend every year since 1962. It has seen taxes raised and lowered, accounting standards changed, presidential assassinations and scandals, recessions, and war.

And through it all, Lowe’s raised its dividend every single year.

Perpetual Dividend Raisers like Lowe’s are strongly aware that shareholders expect annual dividend growth. And if a company has provided higher dividends every year for a few decades, chances are it will do everything it can to continue.

The tax reform bill is hardly a done deal. A lot of details need to be hammered out. But if you stick to Perpetual Dividend Raisers, your dividend income should grow regardless of any new tax laws.

Good investing,

Marc