January 22 , 2003

Most economists agree that funding distortions are created because of the unequal treatment of equity and borrowed capital.  Interest paid on the latter is expensed while dividend payments on the former are not.  Furthermore, corporate and individual tax rates are higher than capital gains taxes for most investors. 

These differences in tax treatments encourage corporations to retain earnings to avoid income tax rates for their investors and borrow money to buy back stock.  By reducing the shares outstanding, stock buybacks may raise the price of each remaining share of stock.  As a result, corporations are able to provide higher after-tax returns to their investors by not paying dividends. 

One danger of this financing is to use too much borrowed money to support stock prices.  A second is to get managers more concerned about stock prices than about asset performance (although some correlation still exists between the two).  Not surprisingly, such managers want more of their compensation to be in the form of stock options, possibly leading to excess manager salaries. 

Those not willing to use stock buybacks may seek stock price appreciation by buying assets.  This could lead to inflated asset prices, inappropriate allocation of capital, and greater instability of corporate earnings. 

The removal of this different treatment between interest and dividend payments should lead to better corporate management, fewer inappropriate mergers, and less risk in corporate balance sheets.  By removing the double taxation of dividends (investors pay through corporate tax when  profits are earned and then through income taxes when dividends are distributed), the cost of capital also will be reduced. 

Because investors can now receive a higher after tax return, they would be more willing to invest in dividend paying companies, causing stock prices in such companies to rise relative to other investments and also to rise relative to where stock prices would be in the absence of such tax changes. 

So, why did President Bush not propose to deduct dividend payments made by corporations?  One answer is simple, Enron.  Giving a tax cut to investors through the tax treatment of corporations they own would appear to be rewarding corporations.

However, the second answer is that expensing dividend payments would be too expensive.  Investors would get benefits for dividends to tax exempt foundations and tax deferred accounts.  By only reducing the income tax paid by individuals in their taxable accounts, the cost of expunging the double taxation of dividends is chopped in half. 

President Bush's program also recognizes that if the corporation decides to retain profits, the additional capital provided by such retention should be treated as if shareholders had received dividends and then purchased more ownership in the corporation.  This leads to an appropriate, but relatively complicated adjustment upward in the cost (basis) of stocks.  As a result, the capital gains ultimately paid would be reduced by these additions to corporate capital. 

There clearly are adjustments that must be made if the tax deductibility of dividends becomes law.  Tax exempt bonds will become relatively less attractive, thus raising the cost of borrowing by state and local governments.  Dividends that are paid from capital that has not been taxed, such as those paid by real estate investment trusts, would not be deductible for individual investors.  Thus, their investment attractiveness also would fall. 

Dividends paid from borrowed money rather than taxable corporate earnings would not receive deductible treatment.  Thus, not all dividends received by investors would be tax exempt. 

In the long run, substantial benefits might develop from the more efficient management of corporate resources. 

However, this tax deduction will do very little to stimulate the economy in the short run. 

Even if stock prices rise because of the reduced tax burden on capital, economic response to changed stock prices is substantially delayed.  Only after 1998 did the "wealth effect" from higher stock prices begin to change the spending decisions of households and the investment decisions of corporate managers. 

Still, the argument that the wealthy will receive most of the benefits from this tax exclusion (a true statement) and will spend much less than poor households is not really true.

As a rule, higher income households save more than low income households.  However, the exception is for high income retirees.  As a majority of dividend income received by individuals is by retirees who are beginning to liquidate their assets in retirement, I can make one economic assumption (that retirees wish to liquidate all their holdings before they die) that would lead to higher spending by retirees from each dollar reduction in tax liability than by the poor who spend all income received. 

In fact, empirical studies on the responsiveness to tax reductions by income class shows much smaller spending differences between high and low income recipients than most politicians assume. 

Having provided all these arguments for the President's dividend exclusion proposal, I must assume that most of this will not become law.  It costs too much (54% of the entire stimulation package in the next ten years).  It is too complicated (changing the capital gains basis for each investor will require many more billable hours for tax accountants).  It does not create jobs in a timely fashion.  And it rewards households who have greater capacity to withstand economic hard times during a period of economic hard times. 

Shouldn't tax cuts in a stimulus package be more focused on those suffering the hardships?   

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