The problem with double taxation

Posted: Aug 01, 2002 12:00 AM
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 than dividends. 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.