David Evanson and Steve Cordasco

TheStreet.com, Fall, 2012

NEW YORK (TheStreet) — President Obama is returning to the presidency and coming with him are the arguments for tax fairness and income redistribution that will characterize the debate in a revenue-starved federal government.

He will need to convince the Republican-dominated House of Representatives of whatever plan he arrives at because they, and not the president, make the laws.

That said, one of the first tax issues to be discussed will be the Bush-era tax cuts that included the favorable treatment of dividends. In recent years, near-zero interest rates have caused income hungry investors to flock to dividend-paying stocks for income and the potential for growth. As the favorable tax regime for that income flow gets debated, investors must now question whether a higher tax on dividends will siphon cash flow from investorszz coffers to the federal governmentzzs.

Furthermore, will dividend-paying stocks decline in value as investors shift away from companies that pay cash directly to investors to those where cash flow is compounded internally and not paid out?

We see a strong likelihood of a change in dividend taxation although we can only speculate on the form it could take. There could be income thresholds, or limits on preferential treatment. For example, we might see an income limit of $250,000 before the higher rate takes effect or a limit of $10,000 in dividends paid per person. Perhaps dividends become taxed entirely as income.

We can hope for clarity but there is less likelihood of taming the grotesque creature known as the tax code and a greater possibility of something that might be called The Accountantzzs Full Employment Act.

The first reaction of individual investors may be to equate higher taxes with sagging prices of dividend-paying stocks. We think this is a mistake. The stock market is composed of many different kinds of investors, many of whom are tax neutral, such as pension funds, where taxes are taken into account only after benefit payments are made. Likewise, income building in your IRA is not taxed until it is taken out, a period that could be some 40 years. So while taxes might make us angry, they are not, ceteris paribus, driving the market.

Dividend stocks have done well, and we expect they will continue to do well. There are several possible explanations for their recent run. It may be due to the fact that dividends have been the major source of return since the Great Bull Market ended 12 years ago.

Further, the near-zero interest rate policy of our central bank has driven down yields on Treasury securities to the point where a 2% dividend looks juicy. Lastly, the rise of dividend stocks may simply be attributable to the fact that regular cash payments are a sign of financial strength in a world where governments and markets are struggling.

To me this says that regardless of the tax environment dividends will continue to be important. But given the marketzzs rotation into dividend-paying stocks, price and valuation are important, too.

In our view, many utility companies have gotten a bit rich lately. Price earnings ratios have risen on solid companies like electricity provider Southern Company (SO), where the P/E ratio went from about 11x in 2008 to approximately 19x very recently.

In contrast, the average P/E ratio of the S&P 500 stands at about 14x. In general, we donzzt like to see growth stock multiples on slow-growth utility companies and we believe the market will adjust this over time. Perhaps this process has begun as demonstrated by SO, which fell off a cliff at the beginning of this month.

In general, itzzs never a good idea for tax implications to drive your investment decisions. True, dividends may be more highly taxed in the future, but they still will provide a level of return in the form of cash flow that is sorely needed by many retirees.

Price is important and a portfolio of dividend payers must be managed very carefully. Presidents and their policies come and go but your needs as an investor must be met with what is available at the time. So for many individuals dividends arenzzt done and remain an integral part of their investment strategy.

While were on the subject, below is a list of stocks to watch that also happen to pay a healthy dividend. Please keep in mind that we may own these shares in our customer accounts.