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Taxes, Dividends, and Distortions

Saturday, June 1, 2002

Had its stock descended from $90 to $1.60 and languished there, Enron Corporation would merely have joined dozens of other casualties of the new economy in Wall Street’s purgatory. But the stock’s final descent, from $1.60 to virtually zero, has instead earned the company a place in the Beltway’s special hell. Now Enron’s name is invoked to buttress every argument imaginable, from reforming campaign finance laws to not reforming the Social Security system. Ironically, the one reform that Enron’s unfortunate history does clearly support still receives scant congressional attention: changing those provisions of the Internal Revenue Code that tax corporate dividends twice.

Unlike dividends, interest payments are taxed only once, so the tax code has nurtured some extraordinarily complex derivative securities that turn equity into debt for the irs and debt into equity for Wall Street. Enron pushed the use of these securities way too far, of course, but reformers who worry that the company’s practices are merely the tip of a vast iceberg might at least consider the origins of the ice. Such consideration may provoke a much closer look at the tax treatment of dividends and how it has bred problems that extend well beyond these issues of corporate accounting.

In essence, tax policy encourages corporations to hold on to shareholders’ money forever. By taxing earnings at the corporate level and taxing them again upon distribution to the shareholder, state and federal government can claim 65 percent of the income. Since over half that tax is avoided if the corporation retains the earnings, shareholders have become more willing to let management perpetually reinvest their money — and management has been even more willing to comply. This policy encourages corporations to find increasingly imaginative uses for their shareholders’ money, including stock repurchase plans that often benefit shareholders much less than they benefit executives who hold stock options.

Disappearing dividends

The internal revenue code has long favored the reinvestment of corporate profits over their distribution. When income taxes first rose high enough to have major economic impacts, the country was fighting World War II and the fine points of corporate finance weren’t part of the public agenda. After the war, when tax policy did become a high-profile issue, there was widespread concern that depression might return unless investment was vigorously encouraged. With dividends taxed at rates over 90 percent throughout the 1950s, there was a strong incentive to plow every cent back into the business.

Even so, the average dividend yield on public companies remained fairly high. Economists were puzzled over the persistence of high dividend yields in the face of such tax inefficiency, and many predicted that dividends would eventually disappear altogether. But until about 10 years ago dividend rates on the stock of large, well-established firms held up fairly well both as a percentage of profit (the payout rate) and as a percentage of the value of the stock (the yield).

In one sense, however, dividends have been falling steadily since the 1950s. The year 1958 was the last time the dividend yield on the s&p 500 was actually higher than the yield on high-quality corporate bonds, reflecting the popular view at the time that investors needed higher equity yields to compensate for the additional risk. Since then, the decline has been steady — and dramatic. (Note also the absolute drop in the dividend yield from 1990 to 2000 — a decline that occurred at the fairly constant rate of 25 basis points per year throughout the decade):

As dividends from major companies declined, the number of firms that pay no dividends whatsoever rose dramatically, from under 30 percent of all public companies in 1960 to over 65 percent today. Shareholders’ appetites for dividends decreased as they became more convinced that when the time came to sell, they could expect large capital appreciation. Meanwhile, corporations have also become more aggressive repurchasers of their own stock, since this is a more tax-efficient way to put earnings into shareholders’ hands.

Therefore, the pressure to alter the tax treatment of dividends has never reached critical mass. Various “flat tax” measures have addressed the issue, generally by proposing that both dividends and interest be taxed at the corporate level and then distributed to shareholders or creditors with no further tax at all. But that has been a tough sell politically. The wealthy passive investor who sits back and receives income from a corporation “tax free” is a tempting target for demagogues, no matter how often it is repeated that the taxes have already been paid.

A better policy on dividends, and one that would have at least some political potential, would have two components:

• First, a change in tax reporting. The 1099 div form, which is the form sent to the irs and to shareholders recording the amount of dividends paid, should also report the amount of corporate tax already paid on dividends distributed.

• Second, tax relief. Individual shareholders should receive an offsetting credit against taxes paid on those dividends. How large a credit? Perhaps ultimately it should be dollar for dollar, but until firm cost data are available it might be much smaller. Certainly, it should be significantly more than the token credit ($400 per joint return) that existed in the tax law prior to 1986.

Although additional reporting requirements are not usually welcome, the one proposed here would aid both corporations and shareholders, because it would underscore the extent to which earnings are taxed twice. Twenty of the 25 most industrialized nations integrate personal and corporate income taxes by various means. Only the United States, Belgium, Luxembourg, Switzerland, and the Netherlands make little or no attempt to avoid double taxation (although the United Kingdom seems to be moving in that direction as well).

This proposal raises other issues — including, of course, the cost of ending this double taxation. But first, in order to make the case for reform, it is necessary to examine the three kinds of mischief the current tax policy has wrought:

• The tax incentives to corporate growth are as powerful for the largest company as the smallest one. Thus, tax policy is at odds with anti-trust policy.

• Dividends could signal useful information about a company, whereas current tax law rewards policies that are more likely to conceal the inefficient use of earnings.

• Alternative methods of getting money into shareholders’ hands (stock repurchases and hybrid debt/equity securities) are overly complex and raise the cost of capital.

Over-concentration of capital

For a few years, Microsoft topped General Electric as the largest company in America, measured by market capitalization. Currently Microsoft has dropped back, but it still has the most cash in the till — $36 billion. Microsoft has never paid a dividend on its common shares and few shareholders are clamoring for change. Yet it is becoming more difficult for Microsoft to deploy its earnings profitably without incurring further charges of anti-competitive behavior. In recent years, a primary avenue of investment for Microsoft has been telecommunications. The company put $5 billion into at&t, $1 billion into Comcast, and lesser amounts into Webtv and other cable ventures. In fortifying its position in the coming convergence of the television and the personal computer, Microsoft has tried to maintain a lighter hand in the world of cable than it did in the world of desktop software. So far it has succeeded in that regard, but the profitability of its new investments remains very much in doubt.

There are some who would rather Microsoft just start paying big dividends. One of the most vocal is Ralph Nader, who claims the company’s no-dividend policy actually runs afoul of the tax code’s provision against the unreasonable accumulation of earnings. In a public letter to Microsoft, he also suggested that the interests of Bill Gates and other major insiders are at odds with the bulk of Microsoft’s shareholders.

On both of these claims, Nader’s evidence is thin. Microsoft may be having difficulty finding suitable investments, but it can certainly show that it is diligently pursuing the effort and hasn’t exhausted the possibilities for putting all that cash to work. As for the claim that Gates’s interests are radically divergent from those of his investors, a popular response from shareholders to Nader has been, “Don’t do us any favors.”

Nader doesn’t even consider the possibility, but a much better answer might be a lower tax on dividends. Microsoft’s investment in, say, at&t hasn’t proven a winner so far, but on a risk-reward basis the shareholders find it defensible. After all, on the risk side of the equation, even a modest chance of success in this field stacks up well against the certainty that if the earnings were paid as dividends, much would be taxed away immediately. Perhaps Microsoft will start paying dividends, but if so they will likely be minimal.

Thirty years ago, large companies that paid sizable dividends were expected to continue doing so. But as newer companies like Microsoft — which had never been under pressure to declare dividends — started to grow large themselves, investors’ expectations changed. It became acceptable for even the biggest firms to retain earnings for future growth, seemingly ad infinitum. A majority of the huge technology companies — including Cisco, Sun Microsystems, Oracle, and Dell — have paid insignificant dividends, or none at all, on their common shares. Instead, these companies used their earnings to fund activities such as the commercial internet, which was good for investors and for the country. But the late 1990s saw a massive over-investment in websites, web hosting centers, internet infrastructure, and software solutions — from which the economy is only now starting to recover.

If earnings had been distributed to shareholders who made their own investment decisions, the same over-funding might have occurred. But is it likely that the internet bubble would have been so enormous without the initial credibility attained as a result of so many large companies’ spreading seed money for so many ventures?

The best example of this is the acquisition binge undertaken by Cisco Systems, which for a brief period in early 2000 was itself the world’s most valuable corporation, sporting a higher market capitalization than either Microsoft or ge. Primarily, Cisco used its high-priced stock, rather than cash, to make the acquisitions. But some cash was needed to cover the transaction costs. Moreover, as the scope of Cicso’s business rapidly increased, it became easier to justify the retention of its cash hoard for future operations.

Cisco’s acquisition strategy made Microsoft’s look like a model of conservatism. Cisco’s largest single acquisition was an optical networking company called Cerent, for which it paid $6.9 billion. The Cerent deal may ultimately show a profit, but it will take decades to do so. Even though Cisco’s own inflated stock was the medium of exchange, the price was enormously high: During 1999, the year it was purchased, Cerent lost $29 million on $10 million in sales.

The Cerent acquisition, more than any other Cisco deal, lent credibility to the initial public offerings (ipos) that were originating in Silicon Valley at the height of the Nasdaq bubble. If Cisco, possibly the world’s most sophisticated technology company, was willing to pay so much for an unprofitable startup, the public could too.

Microsoft and Cisco weren’t the only technology giants whose stock prices assumed unsustainable growth rates. Nor were they the only technology giants that had huge cash assets and paid no dividends. In fact, most of the 100 largest companies on the tech-heavy Nasdaq had the same message for their investors: Forget current returns and keep your eye on huge capital appreciation in the future.

Eventually, there was so much excess investment in technology that it created a financial train wreck. Through its policy of double taxation, the government encouraged profitable firms to retain earnings rather than distribute them. Is it surprising that most of those earnings were invested in the same sector that produced the profits in the first place? If the earnings had been distributed, surely there was a better chance that they would have been spread throughout the economy. Wider choices make for better markets.

Concealing inefficiency

In 1961, future Nobel laureates Merton Miller and Franco Modigliani demonstrated that, in the absence of corporate taxes, a firm’s value is affected very little by how it is financed or by how much of its earnings are paid out or retained. The real determinant of the firm’s value is the way it uses its resources — not its debt-equity ratio or the rate at which it retains its earnings. Miller and Modigliani’s theorem became a centerpiece in the analysis of dividend and payout policy among financial academics. But, as with much economic modeling, it has been used to prove matters far beyond what the authors probably intended. (Modigliani himself has since noted on various occasions that he and Miller differ on the role of taxes in all this. Modigliani considers them to be of much greater consequence.)

Economists have been particularly intrigued by the question of whether dividend growth correlates with earnings growth. In one interesting 1996 study published in the Journal of Financial Economics, Harry DeAngelo and his co-authors purported to test that proposition by examining the dividend decisions of 145 companies listed on the New York Stock Exchange whose earnings had grown consecutively for nine or more years and then began to decline. They found no correlation between management’s dividend decisions and the coming reversal of corporate fortunes. In most cases, dividend increases followed as regularly as when earnings were on the rise.

Many other tests and surveys have been devised by economists; they seem about evenly divided on the question of whether dividend policies send accurate signals about corporate health. But faith in dividends remains strong among a segment of the investing public. They buy books such as the bestseller Dividends Don’t Lie (Longman Publishing, 1988). They see themselves as old-fashioned “value” investors and look at dividends, particularly dividend increases, as management’s way of putting its money where its mouth is. An additional five cents per share, per quarter, sounds far more convincing than a few glowing paragraphs at the front of the annual report, which, although bearing the ceo’s signature, were really written by the firm’s investor relations office. Similarly, an increased payout means more to such investors than the ceo’s upbeat comments to a few financial analysts. In times when even prestigious accounting firms have come under a cloud, it isn’t surprising that many investors seek more tangible evidence of a firm’s prospects than mere words or numbers on paper.

But that’s only part of the story. Since taxes make dividends so expensive, a certain cognitive dissonance pervades the subject. For years, investors were able to earn superior returns by simply selecting the 10 highest-yielding stocks in the 30 Dow Jones Industrials, holding them for one year, and then selling the ones that had dropped off the list and buying their replacements. These superior investments were given the popular nickname “the Dogs of the Dow.” To the extent that the high yield was a function of a low market price, it did mean that those stocks were underloved. But some of the stocks remained among the highest yielding for many consecutive years not so much because their market price was so low, but because their dividend was increasing and their payout ratios stayed high.

Buying the “Dogs” hasn’t worked as well in the past few years, perhaps because the method became too well-known. But another reason may be that so few Dow stocks now pay significant and growing dividends; there is little opportunity for turnover among the 10 highest-yielding. This table underscores how the payout ratio has dropped from the middle of the past decade, after generally staying above the 50 percent range for the better part of a century:

The love-hate relationship with dividend yields is perhaps best illustrated by the stock that had the top yield on the Dow for several years: Philip Morris. The company blends a rare combination of superior current earnings and unsustainable prospects.

So are dividends a sign of strength, weakness, both, or neither? As we descend into the murky world of behavioral finance, paradoxes and doctoral dissertations abound. But even if we set the dissertations aside and stay on the familiar ground of workaday finance, the paradoxes remain. Two money managers, Clifford Asness and Robert Arnott, did their own study of dividend payouts from 1950 to 1991 and subsequent earnings growth over 10-year periods. They found that the strongest earning growth occurred following periods when dividend payouts had been the highest. “My favorite theory is that the cash burns a hole in management’s pocket,” Asness told the Wall Street Journal, “and they over-invest in . . . less attractive projects.” The seminal work of Miller and Modigliani, sometimes labeled m&m’s theorem, was never supposed to mean that cash not paid as dividends will melt in the corporate treasury rather than in the shareholders’ hands.

In an earlier era, the payment of regular dividends was a threshold condition for a stock to be considered an investment rather than a speculation. Vestiges of that philosophy still exist, in the form of constraints occasionally placed on fiduciary accounts that bar the trustee from investing in non-dividend-paying stocks. Attitudes toward dividends would have changed over time even had there been no tax considerations. But with dividend payouts so penalized by tax policy, who knows how stockholders ought to regard a company that pays strong dividends? Do sizable payouts mean that management, having nothing better to do with shareholders’ money, is running out of investment ideas? Or do sizable payouts still convey an understanding on the part of management that profits belong to the shareholders and that placing them in the shareholders’ hands remains a legitimate priority?

If the Internal Revenue Code were neutral in its treatment of dividends and retained earnings, the capital markets would simply sort out these questions on a case-by-case basis. After all, General Electric, which regularly pays substantial dividends, has nevertheless managed to expand and diversify its operations with spectacular success. On the other hand, Berkshire Hathaway, which pays no dividends (but has also shown remarkable growth), has given its shareholders little reason to be concerned about the way the profits are deployed. Berkshire’s ceo, Warren Buffett, is the classic example of the ceo who treats shareholders’ money as attentively as he treats his own. But the tax code is anything but neutral. Consider this illustration:

In other words, the corporation needs to earn about 60 percent as much on retained earnings than would be the case if shareholders’ dividends were untaxed. Since there are large shareholder constituencies (including retirement and pension accounts) that aren’t subject to current taxation, the tax code’s overall “retained earnings subsidy” isn’t as great. But attempts to analyze patterns of shareholder investment based on taxable status have proven unsuccessful because too many other variables intrude.

Let’s grant that the most efficient firms can indeed invest their shareholders’ money more productively than the shareholders can on their own, even with no additional tax cost on the shareholder side. But what about firms that are still attractive, but not in the first tier? By definition, only a tiny percentage of companies stand at the very top of their industries, and they don’t stay there forever. A few people can hold the best investments, at the right prices, for the right time, but markets wouldn’t be markets if everyone could do so. Dividend receipts provide a way for investors to shift financial resources without having to make abrupt decisions gradually. To the extent that those abrupt decisions are perceived as adding to the risk of owning equities, they increase the cost of capital.

Perhaps what has been called the “dividend puzzle” is really part of a larger question: Why do so many shareholders have a preference for the style of investing known as “buy and hold”? But that’s not much of a puzzle. Qualities of permanence and stability are embedded in every popular concept of investment. It may be possible to construct economic models of efficient capital markets in which the length of time that stocks are held is immaterial; it is much harder to find real-world examples. Investors typically know more about companies whose stock they own than about companies whose stocks they don’t own. To compensate for the lack of knowledge about the unowned stocks, investors would expect a relatively better rate of return. Of course, this is just one of many transaction costs in the market; commissions and spreads (between stocks’ bid and offer prices) are more obvious ones. If selling their stock is the only way to realize cash from their investment, shareholders must incur all these transaction costs. In that sense, dividends are a more efficient way for shareholders to claim some of their money.

While there are market forces to prevent management from getting careless with the stockholders’ profits, dividend policy is not one of them. That’s too bad, because the same dollars that are the best source of dividend payments are also those with which it is so easy to become careless. Even when shareholders suspect that “free cash flow” (cash beyond operating and capital needs) is being used ineffectively, there is still little incentive for them to demand higher dividends instead. Thus, an essential brake is lost on some firms’ tendencies to over-expand in their own niches, over-diversify, or over-compensate their management.

The trend of rising executive compensation over the past 50 years closely matches the trend of falling dividends. It is abetted by the use of stock repurchase plans.

Over-complexity

The modern alternative to regular dividend payments is the corporate share buyback. If it is time to distribute money to shareholders, some argue that all a corporation need do is offer to repurchase its stock. Shareholders can sell part of their holdings, and profits on the transaction will be taxed at the capital gains rate. Shareholders who are happy to allow their earnings to remain invested don’t have to sell. Everyone wins.

Well, maybe not quite everyone. Shareholders don’t have equal discretion to sell or hold. If everyone sold proportionately, their relative ownership positions would remain unchanged. In fact, those in the weaker economic position are under greater pressure to sell and eventually may have to liquidate their entire stake. The corporate buyback is like a partnership in which the minority partner asks: “Isn’t it time to distribute some profit?” To which the majority partner answers, “I’m not distributing anything. If you need the money, I’ll buy you out.”

Some would argue that capitalism doesn’t thrive by protecting the weak. But capitalism does thrive by protecting orderly markets. Moreover, a further consideration arises. Corporate financial officers, like other traders, try to buy shares at the most opportune time. To the extent that they are better able to spot market inefficiencies, their use of this knowledge sets up something of an adversary relationship with the selling shareholder, the same one this repurchase program is supposed to benefit.

There is little evidence that corporations systematically outdo the market in buying their own stock, but supporters of share repurchase programs can’t have it both ways. If a corporation has no advantage in timing the purchase of its stock, then why is this activity an effective use of the time and skill of so many high-priced corporate officers?

Make no mistake; a great deal of effort does go into such programs. Early in the game, corporations learned that since they were committed to buying back shares anyway, it might pay to sell put options. By writing a put, which means assuming an obligation to buy a certain number of shares at a stated price within a given time, corporations can earn extra revenue if the stock never falls to the stated price. The option would expire unexercised, and the corporation would simply earn the premium. During bull markets this practice has been highly lucrative. But markets move both ways, and it is not unknown for companies to find themselves obligated to pay well over the market value of their securities.

Consider what happened to Intel in 1998, when the highly cyclical market for semiconductors turned down and Intel’s stock followed for a while. These historical figures are excerpted from Intel’s annual report for the year 2000:

The figures in the right-hand column show the amount of stock repurchased based on market value on the date of purchase. The figures in the left-hand column show the cash required to make the purchases. In 1999 and 2000 the two columns are the same, but in 1998 Intel apparently had to pay $1.2 billion over the market price to acquire its own stock. This exceptional expenditure, which by orthodox accounting practice doesn’t reduce earnings, attracted little notice from financial analysts or the press — despite the fact that Intel has one of the highest profiles among publicly traded companies. Intel is also a highly ethical and open company. It probably could have cleverly disguised at least some of the additional costs incurred in its put option program but chose not to do so. On the statements of many public companies, the stock repurchase data are so opaque that it would be difficult to have the same certainty that all the costs were fully disclosed.

There is another reason that stock repurchases fail as a substitute for dividends. Approximately half of the stock that has been bought back over the past 15 years has not been permanently retired, but rather is used in the exercise of employee stock options. In effect, that reduces the “payout” to shareholders by half. Of course, that’s an average; some firms’ payout would be far more or less. The real problem, with regard to any particular investment, is the enormous complexity of finding out. In this sense, dividends and repurchase plans could hardly be more dissimilar. A shareholder can quickly look up the record of dividend payments in publications from Moody, Standard and Poor, Value Line, or others. But to ascertain the cumulative effect of share repurchase programs on his own equity position, it is difficult for a shareholder to know what to look for, much less to know where to find it.

Corporate management, of course, studies this information closely. Stock option plans are often modified, and options are occasionally repriced to allow executives to buy stock more cheaply when the market has been adverse. Moreover, it has surely occurred to option holders that they stand to gain much more if the company does not pay dividends. How much more? Take a look at the stock options analysis in many proxy statements and you’ll see a line like this for the ceo:

It’s interesting that the boss gets an extra $17 million even when the stock underperforms the historical average (about 8 percent). But note how much more the options are worth if the stock outperforms the averages by a little. Now suppose instead that the stock had achieved that 10 percent return, half by capital appreciation and half by the payment of a 5 percent dividend each year. In that case the options are still worth the lower of the two figures above. The boss could have exercised the option earlier and received the dividends, of course, but that’s just another way of saying that the options’ time value has been vastly reduced. If, in other words, the issue is between repurchase plans and dividends, the former alternative hardly needs the extra boost it gets from current tax law.

The tax laws also favor other complex corporate arrangements over the simple common stock dividend. Using “trust-preferred securities,” a company can form a subsidiary that issues preferred stock that pays a fixed amount regularly. The subsidiary in turn loans the proceeds from the stock to the parent corporation. The parent deducts the interest on the loan, whereas if it had issued preferred stock directly, it could not have deducted the dividend payments. Debt rating agencies don’t consider these shares exactly as loans either, because the ultimate investor — the preferred shareholder — doesn’t have the same legal rights as a borrower.

Variations on this device have been utilized by banks, utilities, and other companies — including, of course, Enron, which apparently had plenty of reasons for wanting to treat loans like assets. In fact, the irs contested Enron’s use of the trust-preferred device in 1996, but it lost. After that, hybrids proliferated even further. The instruments have imaginative names, such as “dividend-paying convertible debt,” “convertible preferred shares,” “stock appreciation-tied principal securities,” and “tax advantage preferred securities.” Besides the mips (monthly income preferred securities) discussed above, they have even more imaginative acronyms — elks, percs, decs, aces, quips, and about 40 more.

Many of these hybrid securities seek, in various fashions, to convert equity-like rewards into debt so that the corporation can deduct the payments as interest. Some are debt instruments with mandatory conversion into common stock at the end of a fixed period. Often, the security is created by a third party, usually an investment bank, that has no fundamental connection to the underlying corporation. This game may be highly profitable for the investment bankers who underwrite all these securities and the brokers who sell them. For everyone else, it’s a heck of a way to run a railroad — or any other industry.

Reform

The proposal advanced here is to amend the tax code in two respects: First, to report the amount of tax already collected on earnings paid out as dividends. Second, to credit individual taxpayers with that tax — or at least as much of it as budgetary and political considerations permit. (It would also make sense to increase the already existing credit on intercorporate dividends.) Similarly, state income taxes should be credited by some offsetting amount of state income tax paid by the corporation itself, even if paid to a different state. This is consistent with other credits that states grant to taxpayers who have paid taxes in another state.

Two other means of ending the double taxation of dividends are usually put forward. So the first question is why this proposal is superior to them. The two better-known alternatives are:

• Tax dividends at the shareholder level just as they are now, but allow corporations to deduct the dividend payments from their own earnings, just as they do with interest payments.

• Eliminate the shareholder tax on dividends entirely, but assure that an adequate tax on earnings is paid by the corporation.

The main problem with the first alternative is that equity and debt are still two different things. The contractual promise to repay money at fixed times and fixed rates is clearly a cost of doing business. It’s a stretch to say the same of dividends, which are solely at the firm’s discretion. Treating dividends as a business expense would have the unintended consequence of making the shareholder even less like the owner of a business than he already is. There is a tendency for strongly entrenched management to run the business for its own benefit rather than for the shareholders. That tendency shouldn’t be exacerbated.

The second alternative — eliminating the shareholder tax entirely — appears in most of the flat tax plans. Since that proposal is usually coupled with a similar treatment for interest payments, it too has the defect of obscuring the differences between debt and equity. But beyond that, the proposal has never drawn an effective political constituency. Too many voters believe that large corporations would still manage to avoid the dividend tax at their level. Others are simply uncomfortable with the notion of “passive” income remaining free from taxation — while salaries and wages are not. Indeed, until 1982, the highest marginal rate on dividend income was 70 percent, while the highest rate on salaries had already fallen to 50 percent.

Taxes should raise the amount of revenue necessary in the most “market-neutral” method unless there is a conscious and compelling reason to deliberately alter market forces through tax policy. The double taxation of dividends is anything but market-neutral. It clearly favors either internal financing of corporations or external financing by means of debt over external financing by means of equity. The corporate tax credit approach suggested here would adjust tax policy to better fit investor preference.

When a startup company is making little or no profit and can’t afford to distribute money to shareholders, any dividends it did pay would carry a very high tax at the shareholder level (because there would be no offsetting credit). When the shareholder received a 1099 showing how much tax he had to pay on those dividends (compared to shares he owns in more profitable companies), he would see this as a highly questionable payout. Just the reverse of this dynamic would occur if the corporation were extremely profitable. Firms that retained their shareholders’ money when it could be paid out with little additional tax consequence would need a strong reason for that action. Theoreticians who believe that dividends ought to be useful signals from management to their shareholders should be pleased with both of these effects.

Beyond the change in reporting requirements, the tax reform proposed here is preliminary and would need to be refined. For instance, should shareholders of private corporations, even those corporations which can elect to be taxed as partnerships, be entitled to a dividend credit? Should the tax treatment of real estate investment trusts (reits) and private investment companies be altered? Are there circumstances under which dividend tax credits could be carried forward? The first step in addressing any of these questions is to acquire better raw data.

According to the Bureau of Economic Analysis, dividend payments constituted 4.6 percent and 4.75 percent of current income in 1999 and 2000, respectively — a percentage that has been fairly constant over the past decade. The bea estimated dividend payments for the two years at $343.5 billion and $379.2 billion. If the reporting requirement proposed here were put into place, it would be much easier to obtain accurate data on the portion of these dividends that are actually double-taxed. How much dividend income flows to tax-deferred accounts? How much income flows from entities such as reits, which are not taxable at the corporate level?

When we know how much revenue is really produced from double taxation, practical decisions can be made as to how large a dividends-paid credit can be put into place. Considering that a substantial credit would almost certainly encourage larger dividend payouts, it is conceivable that the credit could become revenue-neutral. In any case, other adjustments to corporate taxes could compensate for any revenue loss.

No matter how sound the policy arguments are for tax reductions, they are often derided as smokescreens. Opponents say that the real motivation is to lower taxes for “the wealthy.” No doubt that would be said of a dividend tax credit as well. But there will be a growing political constituency for dividend reform as baby boomers move from the accumulation stage to the distribution stage. More investors will want stable returns without making traumatic decisions to sell securities, which can feel uncomfortably like eating the seed corn.

Finally, a dividend tax credit would get government out of the business of favoring one investment approach, which hasn’t proved demonstrably better, over another. Just as that government is best which governs least, so that tax policy is best which has the least impact on the operation of the capital markets. Because of the double taxation of dividends, whole subsets of arcane corporate policy have evolved. If more current profits are paid out to the owners of the corporations, the market will be more diverse and more able to effectively decide how to redeploy that money.