Double Taxation of Dividends: A Clarification


by Confidence W. Amadi

peer reviewedConfidence W. Amadi is an Associate Professor of Finance at Florida A&M University


ABSTRACT: The corporate form of business organization has often been criticized because its profits are taxed twice as a result of the fact that they are subject both to the corporate income tax when earned and the personal income tax when paid out as dividends to individual stockholders. The author of this paper believes that this criticism is based on a misconception because economic units are taxed as payment for their consumption of public goods. Since the corporation and its shareholders are separate economic units, each has to pay taxes, and the  income of economic units is an appropriate basis for allocating the cost of public goods. Furthermore, the author believes that the current corporate tax system reduces the business risk shareholders experience by reducing the variability of corporate earnings.

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          The corporate form of business organization is the most successful form of business in a capitalistic economy because, although it accounts for less than 20 percent of the total number of businesses, it generates more than 90 percent sales and 70 percent of total profits. The success of the corporate form of business lies in the separation of the corporation from its ownership and the resulting limited liability to which  its owners are exposed. Despite its success, the corporate form has been criticized on several grounds, including the difficulty in formation and the agency conflict resulting from the separation of ownership and control. The most important criticism is the double taxation of dividend income accruing to shareholders. [See Van Horne and Wachowicz Jr, 2001, 13-16 and Gallagher and Andrew, Jr, 2000, 13-14 .] The cost of formation can be written off as a cost of doing business. While the agency conflict has received a lot of attention in the literature [See Megginson,1996: 314-336.], the validity of the double taxation argument has, to the best of my knowledge, been ignored or taken for granted. The objective of this paper is to address the apparent misconception of the taxation of dividends and to show that the “double taxation of dividends” is an example of the economic cliché “there is no free lunch.”


          The corporation is a “legal entity” that is created by law in each of the states. It can own property. It can sue and be sued.  It can enter into contracts. Its officers are considered agents of the corporation. Its existence is separate from, and independent of, its owners. The courts have also upheld the corporation’s “right to due process and equal protection of the laws under the Fifth and Fourteenth Amendments.” [Gowri, 1998]  Gowri (1998), also presents an argument regarding the corporation’s right of free speech and political expression under the First Amendment.

One of the failures of the private sector is its inability to provide public goods efficiently.   This is because public goods have almost zero marginal cost.  The cost of one more user of a public good, up to a point, is virtually zero.  Moreover, a public good has the additional characteristic of non-excludability.  This characteristic makes it impossible or impractical to prevent those who do not pay for the good from enjoying the benefits.  Consequently, public good has to be collectively provided by the government.

In a free market economy, the government does not own the factors of production. It must rely on the private sector to produce public goods, while relying on tax revenues to pay for the cost of these goods. Schuman and Olufs III (1993, 414-420), discuss several principles that can guide the choice of who should pay taxes. These principles range from benefits received from government services, ability to pay as measured by their income,  to the concept of tax policies that change people's economic behavior (“sin” taxes). Corporations, as beneficiaries of public goods, are, therefore, required to pay for the services the government provides.

            In the 1980’s, as noted in Schuman and Olfs, President Reagan argued that corporations do not pay taxes; rather, they pass them along to consumers in the form of higher prices. The Reagan administration’s tax proposal would have abolished corporate taxes had a majority of the lawmakers or citizens accepted their argument. The popular view, as suggested by Schuman and Olufs III, “is that they are rich, powerful, and privileged forces in the economy. To absolve corporations of taxes would seriously undermine citizen confidence in the fairness of government.” Thus, in the interest of fairness, corporations have to pay taxes.


             One of the primary benefits of the corporate form of business organization is the separation of the owners from the corporation. Shareholders benefit from the public goods provided by the government. They pay taxes so that the government can purchase these goods  from their producers. Corporations enjoy the same benefits. The fact that shareholders enjoy the benefits provided by public goods in no way detracts from the corporation’s ability to enjoy the same benefits. Shareholders pay their share of the cost of public goods. Corporation, as legal entities, also need to pay their share of the cost of the public goods they consume. Therefore, the corporation and its shareholders are two separate economic units. 

The notion of the double taxation of dividends is predicated on the assumption that it is income that is being taxed. Economic units pay taxes based on their income. Firms, under the corporate form of business organization, are economic units created by the states, with all the “rights and privileges”. Like individuals, they also have income.

            Based on the ability-to-pay-concept, income serves as a means of determining the tax liability of each economic unit.  In allocating a corporation’s costs that cannot easily be identified with a specific product, Generally Accepted Accounting Principles (GAAP) requires that in costing for goods or services, such costs can be allocated based on such factors as direct labor hours or costs, and/or direct material usage. This is the same concept being applied to the allocation of the cost of public goods. In this case income is used as the basis for allocation.

Quiggin (1998) has shown that in the presence of “non-paternalistic altruism towards family members, the sum of private willingness to pay for public goods will equal household willingness to pay which is less than the sum of individual willingness to pay.” This implies that the estimate of the aggregate benefit from public goods will be greater than the willingness to pay of the households as a whole when individual willingness to pay is used as a basis for benefit estimation.  Quiqqin’s findings help explain the rejection of the Reagan Administration’s argument for eliminating corporate income tax. In the context of shareholders and corporations, the shareholders and the corporation can be construed as members of the same household, with the concern about taxation of corporate income a consequence of the household's willingness to pay being less than the benefits accruing to individual household members. Since both the corporation and the shareholders benefit from public goods, the elimination of the corporate income tax would reduce the tax burden on the household without reducing benefits.


The government has more than one avenue through which it can collect the enough revenue to cover the cost of public goods. Several European nations use a form of consumption-based tax or value added tax. The effect of these taxes on the price paid by consumers for private goods and services is similar to the effect of the corporate income tax system. The profitability of a capital project is based on its after tax cash flow. The corporate tax is treated as a cost of doing business and factored into the price the consumers pay for the goods and services. 

The United State could adopt the European tax system, however, as Schuman and Olufs III (1993, 421-422), point out, “ a major problem with consumption taxes is they tend to be regressive. Poorer people consume all of their income.” This line of reasoning attempts to portray a consumption-based tax system as an attack and undue burden on the less fortunate members of society. The argument of Schuman and Olufs applies equally to the corporate income tax system because the price poorer people pay for the goods and services they consume already has the corporate income tax factored into it. This negates the regressive argument against consumption taxes. There is a much more potent reason for the perceived preference of corporate income taxes over consumption taxes. Corporate income taxes are paid only when the firm’s revenues for the period exceeds its explicit expenses, despite the fact that the price the firm receives on each unit of product sold includes a tax mark-up. On the other hand, consumption taxes are based on each unit sold. Retailers merely act as tax collectors for the government.  Moreover, the practice in which corporations are allowed to carry their losses backwards and forwards to offset past and future tax liability strengthens this preference for the corporate income tax.

Consider the hypothetical pro forma income statement presented in Table 1 (below).  Column 2 shows the income statement in dollars, and column 3 is a common size version of the income statement with every account expressed on a per dollar of sales basis. Column 4 is the income statement on a per unit of product basis, with an assumed unit price of $250.00. Column 5 and 6 depict income statement under a 20 percent change in sales volume (in units of product) in either direction.

Based on the sales of 28,448 units, the income tax per unit of product sales is $6.90 or 2.76 percent of sales. Under a simplified consumption tax system, this will be the amount of tax assessed on the consumer for the purchase of the product. The price of the product before consumption tax will be $243.10.  When sales decline by 20 percent to 22,752 units, the tax collected by the retailer for the government will be $156, 989.00 under a consumption type tax system. In the case of the corporate income tax system, the tax liability is $65,287. The difference of $91,702.00, which was already collected through the higher price of $250.00, goes to subsidize the shareholders for the uncertainty in the forecasting of sales, since a payment of the consumption tax will leave the firm with a net income of just $6,229.00, a 97.88 percent reduction in forecast earning. With a 20 percent increase in sales, the tax liability under consumption tax will be $235,552.00, while the corporate tax liability is $327,165.00, a difference of  $91,613.00. The use of consumption tax will leave the firm with a net income of  $582,361.00, a 97.78 percent increase in earnings. 

The degree of combined leverage in a consumption tax environment is 4.89, compared to 3.33 for the corporate income tax environment. Ross, Westerfield and Jordan (2003: 368) note that the higher the degree of operating leverage, the greater is the potential danger from forecasting risk. Since the degree of combined leverage measures the combined effect of operating (a business) and financial risk due to leverage, the use of corporate tax as opposed to consumption tax resulted in a 46.69 percent reduction in the impact of forecasting risk. Thus, the corporate tax system reduces the variability in a firm’s earnings, hence serving to reduce the overall risk of the business. Forecasting risk impacts all firms, with the magnitude dependent on the firm’s use of fixed production costs. As a result, this effect of the corporate income tax system benefits all for profit-seeking organizations.


ACW Manufacturing Inc.

Pro Forma Income Statement for the period ending June 30, 2001





(28,448 units)

Base case

Common Size (%)

Per unit product

Income Statement


 (22,752 units)

20% Decline


(34,138 units)

20% Increase

Net Sales












Gross Margin






S G& A Expense












Interest Expense






Taxable Income






Taxes at 40%






Net Income






          Another benefit that the corporate income tax system confers on shareholders is the loss carry backward and carry forward concept.  This practice allows the corporation to recoup all the taxes it paid on taxable past and future income equal in magnitude to its losses. The net effect of this concept is to make the corporation a free rider on public goods in years when it has a negative income as well as prior and future years until its taxable income equals its loss.

          The argument that describes the tax on corporate income as double taxation indirectly assumes that it reduces the benefits that could accrue to shareholders. In a discussion on the impact of tax differentials on business location, Netzer (1997) reports on the findings that “in a competitive environment for both residents and businesses, the taxes they pay will exactly equal the value they place on the public services they receive.”  Moreover, he argues, that even though businesses pay wages equal to the marginal product of labor, they benefit additionally from the funds local communities spend on education. In the absence of an educated work force, a business can be forced to relocate. Relocation is costly. Yet, with these benefits, local communities offer huge tax incentives to attract businesses. According to Downs (1997), businesses are being subsidized for what they will normally do. This is a loss to the society and a benefit to the firm’s shareholders. If a firm “picks a location that is not the best location, then it chooses a site that is economically inefficient.” This will lead to the production of fewer private goods as well as fewer public goods as a result of the subsidy tax dollars diverted from the production of public goods. On the other hand, if a firm is subsidized in order to induce it to choose a site, it will normally have chosen it on the basis of its own merit; therefore, the business is being subsidized at the expense of public goods. This benefit will flow through to the shareholders. 

The greatest advantage of the corporate form of business organization is the limited liability protection accorded its owners. Taxation of corporate income is the price of that protection.   his price must be worth the benefits since, according to the Internal Revenue Service (1996), corporations account for less than 20 percent of all U.S. business firms, but about 90 percent of U.S. business revenues and approximately 70 percent of U.S. business profits. The benefits of limited liability independent of those enjoyed by shareholders, the flexibility of change in ownership, and the immense ability to raise capital are all derived from the legal entity status accorded corporations by the law. This equal status requires that corporations pay income taxes.


          The “double taxation” of dividends is often cited as one of the disadvantages of the corporate form of business organization. This paper has attempted to dismiss this criticism and show that the separation of the shareholders from the corporation is a sufficient ground for corporations to pay taxes as consumers of public goods. Moreover, the concept of double taxation assumes that it is income that is taxed. Economic units pay taxes. Income is merely a convenient means of allocating the cost of public goods to the economic units that consume the public goods. In addition, this paper has shown that eliminating corporate tax in favor of consumption tax will increase the riskiness (variability) of a firm’s earnings through the increase in the difficulty encountered in forecasting risk. It could also eliminate the subsidies that accrue to shareholders because of the existence of the corporate tax. Finally, in all aspects of the activities of the corporation it is considered independent of its shareholders, and double taxation is an integral part of this separation.


Down, Peter. “Tax Abatements Don’t work. (Tax Abatements in St. Louis, MO),” St. Louis Journalism Review, v27, n193, (Feb 1997),9-10.

Gallagher, Timothy J. and Joseph D. Andrews, Jr. Financial Management: Principles and Practice (Upper Saddle River, 2000), 2nd Edition, Prentice-Hall, Inc.

Gowri, Aditi. “Speech and Spending: Corporate Political Speech Rights Under the First Amendments,” Journal of Business Ethics, v17, n16, (Dec 1998), 1835-1860.

Internal Revenue Service, Statistics of Income Bulletin (Washington, DC: Summer 1996): 137-138, 140-141.

Megginson, William L. Corporate Finance Theory ( Reading, 1996),1st Edition, Addison-Wesley Longman, Inc.

Netzer, Dick. “Discussion, (Impact of Tax differentials on Business Location) (The Effects of State and Local Public Policies on Economic Development: An Overview),” New England Economic Review,(March-April 1997),131-136.

Quiggin, John. “Individual and Household Willingness to Pay for Public goods.”  American journal of Agricultural Economics, v80, n1, (Feb 1998), 58-64.

Ross, Westerfield and Jordan, Fundamentals of Corporate Finance (New York, 2003) 6th Edition, McGraw-Hill Irwin.

Schuman, David and Dick W. Olufs III. Public Administration in the United States (Lexington, 1993),2nd Edition, D. C. Heath and Company.

Van Horne, James C. and John M. Wachowicz, Jr. Fundamentals of Financial Management (Upper Saddle River, 2001), 11th Edition,Prentice-Hall, Inc.

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