Time To Make Dividends Less Taxing
by Charles B. Carlson, CFA
Dow Theory Forecasts

The law of "unintended consequences" says that most actions have effects that extend far beyond what was initially intended. In many cases - especially when it comes to government intervention- these unintended consequences usually are bad. However, that doesn't always have to be the case.

Take, for example, the "double taxation" of corporate dividends. Under our current tax system, dividends are taxed twice - first, at the corporate level in the form of profits; and second, at the individual level in the form of dividend income.

With the Republicans wresting control of Congress, however, it is likely that the punitive taxation of dividends will receive a fresh airing on Capitol Hill, and many experts believe some tax relief for dividends is on the way. Possible changes include:

• The complete elimination of taxes on dividends at the individual level. While this would be a home run for investors, it seems unlikely.
  
  
• A tax break for corporations that pay dividends. Currently, companies can deduct the interest they pay on debt, but they cannot deduct the dividends they pay on equity. One possible remedy would be the ability for corporations to deduct dividends that are paid to equity holders.
  
  
• The sheltering of some amount of dividend from taxes, say up to $500 per year. This change seems the most plausible to me. It's incremental, and politicians generally favor incremental solutions.
  
  
• Reduce the tax rate on dividend income to match the rate on capital gains. Currently, dividends are taxed as ordinary income, which means that taxpayers in the top bracket pay taxes on dividend income at much higher rates than they pay taxes on long-term capital gains. One solution would be to reduce the tax rate on dividends to, say, 20%, which would match the long-term capital gains tax rate.

Obviously, the intended consequences of reducing or eliminating the punitive taxation of dividends would be to stimulate investment in the capital markets and put more money into taxpayer's pockets.

One unintended consequence, however, and it's a biggie, would be to shine a spotlight on corporate financial statements and the financial health of underlying companies.

Indeed, paying dividends is a very concrete way to show that, in fact, the underlying a company's profit statements is real cash, not some phantom accounting mumbo jumbo.

The problem is that companies today still have too many excuses for not paying dividends, and at the top of the list is the punitive taxation on those dividends. Companies argue that their shareholders don't want dividends; they want capital gains, which are taxed at lower rates. And that means the best use of corporate cash is not to pay dividends but to fund growth initiatives or buy back stock.

Of course, companies may use these excuses when the real reason they don't pay dividends is the fear that the fiction of their accounting statements will eventually catch up with the reality of having to fork over cash to shareholders every quarter.

Without the punitive tax argument, however, corporations would be forced to pony up dividends or face the following questions - Why doesn't your firm pay dividends? Does your income statement reflect your true profitability? If you are not paying out dividends, what are you doing with your cash, and why?

Bottom line: Better tax treatment for dividends is not just good tax policy. It would also go a long way toward increasing the transparency of corporate financial statements.

And that should matter to politicians on both sides of the aisle.

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