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President Bush's proposal to reduce taxes on corporate dividends
is being attacked by Democrats as another give-away to the rich. But not too
many years ago, it was Democrats who were in favor of this policy and
Republicans who were against it.
In 1976, Democrat Jimmy Carter made elimination of the double
taxation of corporate profits a key campaign theme. "We presently tax
corporate income when it's earned, and we also tax dividends to
shareholders," he said. "I would favor taxing income only once," Carter told
When President Carter took office in 1977, he reiterated his
goal of taxing corporate income only once and had the Treasury Department
examine the issue. He received support from many voices of liberalism in
this effort. For example, Americans for Democratic Action called for
abolition of the corporate income tax at its convention in May. On Sept. 11
of that year, The New York Times editorialized in favor of this action.
Unfortunately, Carter failed to include any proposal for
reducing or eliminating double taxation in his 1978 tax reform plan. The
reason, interestingly, appears to have been opposition from the
Republican-leaning corporate community. According to an article by Robert
Samuelson in the National Journal in September 1977, businesses basically
killed the idea.
According to Samuelson, corporate executives suddenly had a lot
of problems with the idea of eliminating double taxation once confronted
with its possible reality. Some worried about increased pressure to pay out
dividends. This especially concerned small businesses that normally don't
pay dividends. Executives also feared a loss of control over retained
earnings, which they could invest as they chose. And they saw many specific
tax breaks as better for them.
Another reason, I have always believed, is that the corporate
income tax acts as a kind of shield protecting corporate executives from
shareholders. It allows them to pay themselves inflated salaries and waste
shareholder's profits on expensive perks and investments of dubious value.
Since such things are deductible business expenses, shareholders are fooled
into thinking that they are not costing them anything. Without such
deductibility, it would be harder for executives to justify their behavior.
Academic research supports this analysis. Writing in the Yale
Law Journal, legal scholars Jennifer Arlen and Deborah Weiss argue that the
corporate tax forces shareholders to go along with the wishes of corporate
managers even if they don't agree with them. Double taxation encourages
companies to retain earnings rather than pay dividends. So even if managers
make bad investments and shareholders have better investment opportunities,
it still pays for shareholders to support retained earnings and low
Another widely commented upon result of double taxation is
encouraging companies to raise capital through debt rather than equity. That
is because interest payments are tax deductible, whereas dividends are not.
The result is for companies to become heavily leveraged and make capital
less available to small businesses and new startups.
The overall impact on the economy is to reduce the rate of
return on corporate capital, which slows economic growth. Big established
companies have easy access to capital through the bond market and retained
earnings, while being protected from potential competitors because the
latter cannot raise capital, or only at much higher cost.
What cutting taxes on dividends, as President Bush proposes,
should do is raise the value of companies paying dividends. That is because
the tax is now capitalized into the price of stock. Thus lowering the tax is
equivalent to an increase in profits.
Although the tax capitalization thesis is controversial among
economists, the latest research strongly supports it. Indeed, Council of
Economic Advisers Chairman Glenn Hubbard is the author of much of this
research, while a professor at Columbia.
Economic John Rutledge estimates that the complete elimination
of taxes on dividends would raise the Standard and Poor's 900 index by 8.5
percent, or $800 billion. Principal beneficiaries would be companies with
high dividend payout rates and low debt. However, as managers alter business
strategies by reducing debt and raising equity and dividends, other
companies will also benefit.
This estimate is consistent with the experience of New Zealand,
which completely abolished double taxation of corporate income in 1988.
According to a recent article in the Journal of Business Finance and
Accounting, the result was that low-debt firms gained, significantly while
high-debt firms saw their stock prices fall. However, as time went by, debt
levels at New Zealand companies fell across the board.
President Bush is right to try and relieve the double taxation
and overtaxation of corporate income. Not only will it increase the
economy's long-term growth potential, but could provide short-run stimulus
by boosting the stock market