BOSTON ( TheStreet) -- If the tax rate on dividends spikes at the end of the year, millions of investors will share in the pain.

Dividends are taxed at 15%, and the Obama administration has signaled -- most recently by Treasury Secretary Timothy Geithner to CNBC's Larry Kudlow -- that it supports a relatively modest increase, to no more than 20% at the top rate. But inaction by Congress would mean that, in 2011, qualified dividends will no longer be taxed like capital gains, but instead treated as ordinary income at a rate that would top out at 39.6%.

Among those leading the charge against that scenario are utility companies, many of which offer the fattest yields. In 2009, companies such as PG&E ( PCG), Duke Energy ( DUK) and Exelon ( EXC) paid out $18.5 billion in dividends.
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"You would be looking at a real hit across the board if the federal tax on qualified dividends reverts to marginal rates, which is a distinct possibility," says Jim Owen, spokesman for the Edison Electric Institute, an association of shareholder-owned electric companies. "If we move to a situation where dividends are going to be much more heavily taxed, it will impact share valuations, which would affect our credit quality and weaken or compromise our balance sheets and liquidity. It could create a situation in which utilities start moving much more heavily into debt financing rather than equity financing, and we could end up with lower bond ratings. It is going to end up costing utilities more money, which ultimately gets passed on to customers."

The Edison Electric Institute's concerns, if they bear out, would affect other companies too, and have a trickledown effect.

Investors would see their returns diminished. But so too would the millions who own dividend-paying stocks through mutual funds, IRAs, pension funds and 401(k) plans.

Many investors carefully consider dividends when they choose stocks for their 401(k) plan, counting on the quarterly payouts to hedge against the underlying stock price while growing their portfolio. Though tax-advantaged retirement plans would seemingly be insulated from rate hikes, the impact would be felt in other ways.

If, as some warn, the higher tax curtails investment and lowers cash flow to cover capital-spending plans, companies could face the choice of cutting dividends and diverting the proceeds for other needs.

It would not be unheard of. In fact, during the past two years, many companies have reduced or suspended dividend payments due to the recession or sector-specific woes. Among them: JPMorgan Chase ( JPM), Wells Fargo ( WFC), Capital One ( COF), General Electric ( GE), Honda ( HMC), Ford ( F) and Toyota ( TM)Toyota. In 2009, S&P 500 member companies trimmed dividend payments by $52.6 billion.

In turn, retirement plans and mutual funds would have smaller gains to reinvest. If the lure of quality dividend payments is diminished, investors may turn away from specific stocks, further eroding returns.

-- Reported by Joe Mont in Boston.


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