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
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
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?