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Just Say "No" to Dividend Taxation By Stephen J. Butler

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Harry Truman, when preparing to turn the Presidency over to Dwight D. Eisenhower, made the comment that the former commanding general would be totally amazed at the new experience of issuing orders and having nothing happen.

Efforts at tax simplification offer just a dizzying array of possibilities. Everything from a flat tax of 20% to a giant national sales tax have been floating through the halls of Washington, but no single approach can manage to get traction. Why? Because no powerful interest group really wants tax simplification. They all want special tax breaks for themselves, and this is where they spend any "band width" that they can allocate to tax-related issues.

Overall tax simplification benefits everybody, so no single company or special interest gains an advantage over others by promoting it. Unfortunately, special interests determine the outcome of most proposed legislation, so tax law changes reflecting common sense will remain bottled up in think tanks. This is how our government works. It would be interesting to have a reality show like "The Osborns" that depicts the real-time machinations of lobbyists and lawmakers as they discuss legislation and campaign contributions over lunches and in the halls of Congress.

Paddling upstream, Treasury Secretary Paul O'Neil insists that there has to be some way to achieve some progress. He points out, for example, that the tax code includes five separate definitions for the word "child." I think our esteemed Secretary has the experience to recognize that any progress at all will result from "eating an elephant one bite at a time."

So, I have a suggestion. I propose that corporate dividends not be double-taxed. Dividends represent company profits that are paid out to stockholders. Companies pay corporate taxes on this money and then investors pay personal income taxes on dividends they receive in any calendar year. If companies didn't have to pay taxes on dividends, they would be more inclined to pay them out. Individuals receiving presumably higher dividends would have more taxes to pay, so the loss to the government wouldn't be that great, but something else more positive and important would happen.

Some recent analysis indicates that companies that pay dividends actually demonstrate more growth in value over time than those that reinvest profits instead of paying them out. This is counterintuitive. Common sense would tell us that a company should grow faster if it takes what would have been paid-out dividends and taxes and invests them instead in other internal investments, like research and development, that contribute to additional value.

Unfortunately, the facts don't bear this out. Research done by Robert Arnott and Clifford Asness going back to 1871 show that corporate profits grew fastest in the ten years following the highest average dividend rate pay-out. The lowest growth rates were seen in the ten years following the lowest average pay-out ratios. The theory today is that corporate managers with extra profits on their hands tend to squander them. They engage in empire-building and ego-inspired acquisition strategies that are statistically doomed to failure. While a number of academics are now piling on to this theory, it isn't necessarily new news. Mark Hulbert, in the New York Times, points out that as early as 1986, Michael Jensen at the Harvard Business School speculated that the more cash companies have now the less efficient they will be in the future.

If managers can't spend what should have been dividends, they are forced to go to capital markets to borrow or they need to sell stock to fund future ventures. This requires a more disciplined screening process for new ventures than just having one's way with corporate cash.

The fact that dividends are taxed at the corporate level offers a toehold of rationale for why they should be reinvested (or even paid to management) instead of being paid out to stockholders. To remove taxation on corporate dividends would remove at least one reason for this misguided activity. We investors would still pay taxes on dividends we receive as stockholders. For most of us average Americans, however, the bulk of our stock holdings are in mutual funds which, in turn, are in IRA's, 401(k) and other retirement plans. Most of us have our nest eggs piling up in these tax deferred accounts, so dividends avoid immediate taxation and just become part of the total pool we access and pay taxes on at retirement someday.

This proposal is not exactly revenue neutral. Corporate taxes represent about 10% of the total taxes collected. The portion of corporate taxable earnings paid out in dividends is probably only 1 or 2 %. Some of what is saved on the corporate side will lead to additional tax collections over on the personal side if we have more dividends to spend thanks to the corporate tax savings. In the end, the cost to the government may only be 1%, but if company management had the incentive to pay out more dividends and become more profitable as a result, then taxes overall will increase to more than make up the 1%.

In a famous Stanford experiment, shoppers confronted with 26 types of jam bought almost no jam. Those confronted with only 6 types of jam bought tons of jam. Too much choice leads to analysis paralysis. If we want to simplify taxation, we need to start with a few simple ideas that would have broad "win-win" benefits that few have any reason to dispute. My vote goes for doing away with taxes charged to corporations. We simplify, we benefit from increased efficiency, and most of us defer the personal tax on our dividends until we retire. I don't care what anyone else thinks, but I say that having a big income tax problem throughout our retirement years is a delightful problem to have. It means we have plenty of money.