DOUBLE TAXATION OF DIVIDENDS: A CLARIFICATION
by Confidence W. Amadi
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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, PUBLIC GOODS, AND TAXES
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.
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
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
economic behavior (“sin” taxes). Corporations, as beneficiaries of public goods, are, therefore, required to
pay for the services the government provides.
THE CORPORATION AND ITS SHAREHOLDERS
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.
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.
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
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.
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.
TAXES AS A BENEFIT TO SHAREHOLDERS
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.
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.
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
Common Size (%)
Per unit product
S G& A Expense
Taxes at 40%
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.
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
all derived from the legal entity status accorded corporations by the law. This
equal status requires that corporations pay income taxes.
“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
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.
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