The problem with double taxation
8/1/2002 12:00:00 AM - Bruce Bartlett
As investors look for long-term fixes to the stock market's
problems, new attention is being focused on the role of tax policy in
encouraging them. In particular, the double taxation of corporate profits
led managers to change corporate financial policies in ways that contributed
to current difficulties.
When an individual or a group of individuals in partnership form
a business, they face just one layer of taxation on their profits. These are
taxed only by the individual income tax at rates that now go up to 38.6
percent. But if they choose instead to organize as a corporation, they pay
an extra tax of 35 percent at the corporate level, plus the individual tax
on after-tax profits paid to shareholders. Thus the total tax rate on
corporate profits is 60 percent, versus 38.6 percent on those earned by a
sole proprietorship or partnership.
This has long made the corporate form of business
disadvantageous from a tax point of view. This is offset to some extent by
the limited liability that corporations enjoy, endless life and easier
access to capital. Nevertheless, there is no logical reason why two
businesses of equal profitability should pay sharply different tax rates on
their earnings based solely on their legal form of organization.
One consequence of the corporate income tax, which came into
being in 1909, is that it has lessened shareholder control over corporate
assets. A key way shareholders exercised control in the pre-corporate tax
era was by demanding that firms pay out a large percentage of their profits
in the form of cash dividends. Among other things, this helped guarantee
that corporate earnings were "real" and not based on creative accounting. At
this time, it was common for companies to have a dividend-price ratios of
about 5 percent.
Eventually, companies and shareholders figured out that it was
mutually beneficial either to retain corporate profits, thereby raising the
value of company assets, or use those profits to buy back shares on the open
market. The effect of both strategies is to raise stock prices. Thus,
shareholders get their earnings in the form of capital gains, rather than
dividends. Not only are capital gains more lightly taxed than ordinary
income, but shareholders themselves decide when to pay the tax, since
capital gains taxes are assessed only when shares are sold.
The flexibility afforded by receiving one's profits as capital
gains allowed sophisticated investors effectively to pay nothing except the
corporate tax. They could eliminate even the capital gains tax on their
shares by realizing gains only when they had offsetting losses, or by
borrowing against their shares.
As a consequence, there has been a steady decline in the number
of companies issuing dividends and the amount of such pay-outs. According to
economists Eugene Fama and Kenneth French, the percentage of large companies
paying dividends in a given year has fallen from 68.5 percent in 1978 to
21.3 percent in 1998. Over this same period, the dividend yield fell from
5.28 percent to just 1.49 percent. In effect, most shareholders are now
getting virtually all of their investment returns from capital gains rather
Unfortunately, in the process, investors lost an important
source of control over the assets they ultimately own. Freed from the need
to come up with hard cash to pay quarterly dividends, corporate managers had
much more flexibility in how to present a company's performance to
shareholders. Although Securities and Exchange Commission rules and
accounting conventions theoretically kept them honest, inevitably there were
gray areas that could be exploited by aggressive managers.
Another consequence of double taxation is that companies began
raising less of their capital from issuing shares and more from selling
bonds. This made sense because interest payments are tax-deductible, whereas
dividends are not. In 2001, U.S. companies paid out $554 billion in
interest, versus $417 billion in dividends. However, this increased leverage
makes them more vulnerable to economic downturns and often pushes companies
into bankruptcy when interest payments cannot be met.
For these reasons, many economists believe it would be much
better for companies to go back to paying dividends, and rely more on equity
to finance expansion and less on debt. Paying dividends will reduce the
incentive to use creative accounting, and more equity will help companies
ride out temporary downturns. (Dividends can be reduced or suspended when
profits fall -- interest payments cannot.)
But these beneficial reforms will not occur as long as the Tax
Code continues to double tax corporate profits.