Despite Fiscal Cliff, Dividend Outlook Not All Bad

A possible reason is that U.S. stocks are sliding Wednesday is that investors now view the chances of the fiscal cliff arriving as heightened following President Obama's re-election. In the days leading up to the election, the Obama Administration promised to veto any legislation aimed at avoiding the fiscal cliff that did not include tax increases for the wealthiest Americans.

Not only could the fiscal cliff sap $600 billion in U.S. GDP and cause another recession, it is viewed as potentially damaging to dividend stocks and the ETFs that track those equities.

Conventional wisdom says that when tax rates on dividends rise, companies are less inclined to pay and increase shareholder payouts. Not surprisingly, investors view the consequences for dividend ETFs as negative.

However, the impact on payouts and dividend-paying stocks and ETFs may not be as bad as some investors are thinking, according to new research from ETF issuer WisdomTree (NASDAQ:WETF). WisdomTree's research assumes the Obama plan to raise taxes those earning more than $250,000 per year.

At that income threshold, 52 percent of dividends would be subject to the tax increase, WisdomTree noted, citing IRS data from 2009.

"While dividend-paying investments represent the majority of the market, only about half of qualified dividends would be subject to the harshest dividend tax increases," according to the research. "If tax fears cause dividend stock prices to fall, this could make them more attractive for tax-insensitive accounts. In fact, approx. 40% of the equities held by U.S. investors are in tax-deferred retirement vehicles, and therefore, not immediately impacted by any changes in dividend tax rates."

The potential impact on dividend ETFs could be palpable. These funds have been among the most prodigious gathers of ETF assets this year. Thirty-two dividend ETFs tracked by Dorsey Wright & Associates collectively grew assets by 40 percent through the end of the third quarter compared to asset growth of 23 percent for all ETFs, according to data from that firm.

Several WisdomTree ETFs have been the beneficiaries of increase inflows to dividend ETFs. The WisdomTree Emerging Markets Equity Income Fund's (NYSE:DEM) has more than doubled this year while inflows to other global funds such as the WisdomTree Global Equity Income Fund (NYSE:DEW) and the WisdomTree International Div ex-Financials ETF (NYSE:DOO) have been robust as well.

There are other factors that could work in favor of income investors even if the fiscal cliff comes to pass, including dwindling payout ratios. WisdomTree said payout ratios have been dropping for the past three decades.

"We therefore believe the impact of a tax hike is less severe than it might have been in the past because, to put it simply, firms are paying out less of their earnings as dividends," according to the research.

As WisdomTree points out, it is worth noting the dividend tax went up in 1993, but the highest-yielding stocks performed quite well from the end of 1992 through the end of 2002. Said another way, market environment is more important than the tax landscape.

Going back to November 2011, the market environment has been quite favorable to dividend ETFs. Over that time, the Vanguard Dividend Appreciation ETF (NYSE:VIG), the SPDR S&P Dividend ETF (NYSE:SDY), the iShares High Dividend Equity Fund (NYSE:HDV), the WisdomTree U.S. Equity Dividend Income Fund (NYSE:DHS) and the WisdomTree U.S. LargeCap Dividend Fund (NYSE:DLN) have returned an average of 15.4 percent including paid dividends. All five of those ETFs have also been less volatile than the SPDR S&P 500 (NYSE:SPY) over the same time frame.

Bottom line: A dividend tax increase will not be the best news in the world, but it may not spell disaster, either.

"For equity investors, there is little question or debate about the fact that lower dividend tax rates are preferable to higher dividend tax rates, but we hope people recognize and understand that, historically, dividend tax rates have tended to be much higher than 15% and dividend--paying equities have still delivered attractive returns," according to WisdomTree.

For more on dividend ETFs, click here.