Articles

There's Only Limited Appeal to Repealing Dividend Tax

Monday, March 3, 2003
by Marc J. Lane

Reprint permission from the March 3, 2003 issue of Crain's Chicago Business.

More than 400 economists, 10 Nobel laureates among them, have harshly criticized President George W. Bush's controversial initiative to end the "double taxation" of corporate income. They were justified in challenging the president because they know that his plan, bold as it is, widely misses the mark.

Repealing the income tax on corporate dividends simply wouldn't lift the stock market, create jobs or improve corporate accountability, as our MBA in chief hopes it would. He should back away from his ill-conceived proposal and instead promote tax relief for companies that pay dividends.

 

The president is absolutely right when he insists that the double taxation of dividends impairs our economy's long-term health. With the combined effect of corporate and individual tax rates, the government extracts up to 60 cents out of every dollar a company earns and then distributes to its shareholders as dividends.

When taxes are confiscatory, people always find a way to avoid paying them. Since companies can deduct interest expenses from their earnings, but not dividends, they prefer to borrow money instead of selling stock. So, the fate of the economy rests uncomfortably on the shaky balance sheets of companies that have taken on more debt than they should.

Those companies go on to reward their shareholders by driving up stock prices instead of paying dividends. Managers end up worrying more about the earnings they report and less about the cash they pay out to shareholders. And, for some, the lure of accounting chicanery may be too strong to resist.

But few critics of the president's dividend-cut-to-the-rescue plan believe that taxing corporate profits only once can boost the nation's lackluster growth rate this year, or anytime soon.

The plan's detractors also point to a state-by-state ripple effect. Illinois' and other states' revenues are tied to federal tax law. According to the non-partisan, Washington, D.C.-based Federation of Tax Administrators, Illinois stands to lose about $140 million a year in taxes on dividends. Unless the president's tax-only-once strategy jump-starts the state's economy fast enough to offset that shortfall by additional sales and income taxes, Illinois' huge budget gap would only widen.

At the same time, Illinois' and other states' borrowing costs would likely increase. The Center on Budget and Policy Priorities, a liberal think tank in Washington, ran the numbers and credibly concluded that a dividend tax cut would draw money into dividend-paying stocks and away from tax-exempt bonds, the securities most states use to fund major building projects.

Moreover, executive compensation packages and insider stock sales are under increased scrutiny. But dividend payments are not.

When Microsoft Corp.'s board recently decided to pay its first-ever dividend of 16 cents a share, the owner of a 1,000-share position booked dividend income of $160. Compare that with Microsoft Chairman Bill Gates, who earned $99 million, and CEO Steve Ballmer, who earned $37 million, based on the company's last proxy statement.

Surely, Microsoft's bosses didn't put their own interests before other shareholders'. But that doesn't mean that other shareholder-executives wouldn't, especially those eager to bolster their take-home pay and profits on their sale of company stock by grabbing tax-free dividends.

The wiser approach to dividend tax relief would let companies deduct their dividend payments, but require that their shareholders continue to be taxed on them. If dividends were treated like interest payments, managers would have no tax incentive to skew balance sheets toward debt.

 

Marc J. Lane ([email protected]) is a Chicago lawyer and financial planner and an adjunct professor of law at Northwestern University School of Law.

 


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Copyright © 2003 by Crain Communications Inc.

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