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Will the dividend tax rise cause a stock market crash?

Arrow descending on a graph portraying stock market crash
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Since the National Insurance hike hit the news last week, tax increases have been at the forefront of my mind. But the tax rise I’ve been mulling over isn’t the NIC increase, it’s the dividend tax rise, which will be introduced from April next year. Under the new plans, investors will pay more on dividend income to the tune of an extra 1.25%. This increase will push basic rate dividend tax up to 8.75%, and is being levied to help support the NHS and social care. The big question for me is whether this tax hike could lead to sell-offs, or even a stock market crash sometime next year.

Dividends tend to reward longer-term investors who buy shares in companies that prioritise rewarding investors with regular payments. If the dividend tax rise starts to make this kind of investment look less desirable, which shares could be at risk of a sell-off? Potentially vulnerable are the so-called ‘Dividend Aristocrats’ like Diageo and DCC – companies that have raised their dividends annually for at least 25 years. One concern is that once dividend tax increases, these firms could start to lose their ‘USP’ as investors switch strategies and look to stocks that offer growth potential instead. But given that the ‘Dividend Aristocrats’ are so focused on meeting investor expectations, I think that they could actually prove more resilient: the dividend tax rise might persuade investors to switch away from lower-yielding UK stocks instead.

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Another factor prompting my thoughts of a stock market crash are the low dividends paid out over the pandemic. 2020 saw two thirds of companies cut or cancel payments, leading to £14.5bn of lost dividends. Could the double trouble of these low payments and higher dividend taxes cause investors to lose faith in investment stocks? If so, we could see a period of mass sell-offs and even a stock market crash as a we approach the new financial year.

But it is worth noting that dividend payments seem to have made a strong recovery so far this year, jumping by 61% compared the same period in 2020. The dividend tax increase could also have the unexpected impact of encouraging more buybacks, which act as an alternative way for firms to give back to investors. Under share buybacks, companies repurchase shares, which typically pushes up share prices and offers investors the opportunity to sell their shares at a premium. If the dividend tax increase encourages firms to offer buybacks as an alternative to dividends, the risk of investors running for the hills could be lower.

Overall, I think the upcoming dividend tax rise looks unlikely to cause a stock market crash. The increase is relatively modest, and when the dividend tax-free allowance was cut by more than half in 2018, we didn’t see evidence of the market crashing. But I’m taking it as a sign that the government is looking for increasingly innovative ways to raise money, and that I need to look for increasingly innovative ways to invest!

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Hermione Taylor does not have a position in any of the shares mentioned. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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