THE SMITH CENTER

for Private Enterprise Studies

Double Dip Dividend Taxation

by
Micah Frankel
Associate Director

Under our current punitive tax regime, corporate earnings are taxed at least twice: once at the corporate level and then again at the shareholder level. Even though the shareholder is considered the owner of the capital (residual claimant) of the corporation, for IRS purposes, two separate tax entities exist, the corporation and the shareholder. Thus, the corporation computes its taxable income before deducting or paying any dividends to shareholders. Consequently, the dividend is "taxed" at the corporate level. If and when the corporation pays a dividend (a distribution to the shareholders of current year earnings or accumulated earnings), the dividend is taxable to the owner upon receipt. Thus, in effect, the dividend has been taxed twice.

Example:
A corporation has taxable income of $100,000 and will pay a $40,000 dividend out of these after-tax earnings. If the corporation's tax rate is a flat 35 percent, it will pay $35,000 in taxes ($100,000 x 35 percent).

If the corporation had been able to deduct the dividend, it would have paid only $21,000 in taxes ($60,000 x 35 percent). Its taxable income would have been reduced by $40,000, and its taxes reduced by $14,000 ($40,000 x 35 percent).

So in effect, the corporation is taxed on the $60,000 ($21,000) plus the dividend of $40,000 ($14,000). The dividend is "taxed" at the corporate level (because it is not deductible), and it also taxed when received by the shareholder.

From an income perspective, the firm is initially taxed when it earns income, these after-tax earnings are then taxed again at the shareholder level when distributed to the shareholders. That is, the shareholders who receive dividends also receive a form 1099-B from the paying corporation stating the amount of dividends they have received. These dividends are then included in the shareholders income and taxed at the shareholder's marginal rate. The result of this punitive tax (for the top tax bracket) is an effective tax rate which exceeds 70% of these initial corporate earnings. According to a Cato Institute survey, the US is only one of three of the world's 30 developed nations to double tax corporate income. Of these three countries, the US has the highest corporate tax rates.

Example:
Corporation has taxable income of $100 and is taxed at 35% for federal taxes plus 10% for state taxes. This leaves the corporation with $55 to distribute as dividends to its "owners," the shareholders.

The shareholders receive this $55 and must pay 38.6% for federal taxes plus 10% for state taxes. This leaves the shareholders with $28.27 of the original $100 of corporate earnings. Note the amount retained by the shareholder after taxes may be higher if state taxes can be deducted on the federal return.

Even if a company retains and reinvests its after-tax earnings, these earnings are taxed again, at the capital gains tax rate when shareholders sell their stock. This is often referred to as the "double taxation of retained earnings." Of course, upon the death of the shareholder, "triple taxation" will occur if the value of shareholder estate assets exceeds the $675,000 estate tax threshold. In this case, the shareholders' heirs will be taxed on the excess, up to 55%. If these heirs decide to invest their inheritance, the taxing cycle begins again.

Leveraged Unstable Companies

When combined with the deductibility of interest on debt, the punitive double tax on dividends introduces a tax bias against equity financing, and encourages companies to become more highly leveraged (that is to finance assets using debt). This results in more volatile companies and an overall economy which is more susceptible to business cycles. Financial leverage is risky. Unlike financing with equity where dividends are discretionary, when financing with debt, the interest and principal must be paid regardless of the firm's profitability or cash flows. If the firm is unable to make its debt payments, it must go into reorganization or bankruptcy. Thus, all else equal, the more debt a firm has the lower its financial flexibility and the higher its probability of financial distress.

Example:
A corporation issues $100 million of common stock to finance a new factory. The factory earns $10 million a year in profits. This $10 million is taxed at 45% so the total taxes paid by the corporation are $4.5 million.

A corporation obtains a 6% bank loan for $100 million to finance a new factory. The factory earns $10 million a year in profits. This $6 million of interest is deducted from the $10 million in profits so that only $4 million is subject to taxes. Total taxes paid by the corporation at 45% are ($4 million x .45) or $1.8 million.

The Solution to Double Taxation

Former Presidents John F. Kennedy, Gerald Ford, Jimmy Carter and Ronald Reagan have advocated the elimination of double taxation of dividends, and on January 7th, 2003 President Bush followed suit when he unveiled his "pro-growth economic stimulus plan." One prominent feature of the plan was the elimination of taxes shareholders pay on dividends. "I am asking the United States to abolish the double taxation of dividends," The President said. "By ending this investment penalty we will strengthen investor confidence. By ending double taxation of dividends, we will increase the return on investing to draw more money into the markets, to provide capital to build factories, to buy equipment, hire more people."

The President's comments are backed by a 1992 study by the Treasury Department which concluded that ending the double tax on dividends will increase the capital stock in the corporate sector-the most productive sector of the economy-by up to $500 billion, and produce an annual gain to the U.S. economy of up to $25 billion. When adjusted for the growth of the economy, this translates to more than $40 billion per year in current dollars.

Predictably, the Democrats, resorted to their tired hate-envy class warfare mantra and complained that the president's plan is not fair because it will disproportionally benefit the "winners of life's lottery" i.e., the "rich." The President's response is that "economic fairness" should rule; thus, those who pay taxes, are the ones entitled to tax relief.

Again the President's comments are backed by empirical data. According to the IRS statistics, in 1998, the top 1% of taxpayers (about 1 million people) paid about 35% of federal income taxes (up from 19% in 1978). In 2001, the 400 wealthiest taxpayers in the U.S. paid $8.7 billion in taxes, which is about as much as the 40 million taxpayers at the bottom of the scale paid.

It is difficult to receive a tax refund if you didn't pay taxes in the first place. The bottom 40% of taxpayers contributed about 1% of income tax revenue; yet, millions of low-income Americans who pay little or no federal income taxes collectively receive a check for more than $30 billion (a negative income tax).

Politics aside, many critics of the President's plan are confusing the concepts of submitting taxes and bearing the burden of taxes. While it is true that "the rich" will submit less taxes to the US Treasury, under the President's plan, it is the working class, who will benefit by bearing less of the burden of double taxation. The working class benefits when the scarce resource "capital" is allocated to its most productive users. Once infused with capital, these user firms will invest in more productive facilities and equipment which will result in increased productivity. With increased productivity comes increases in real wages and increases in the standard of living.

Double taxation of dividends encourages corporations to retain earnings, even to the point of making investments which earn less than their opportunity cost of capital. After all, if the money is distributed to shareholders so they can invest it at higher rates elsewhere it will be taxed again. As a result, companies are under pressure to reinvest earnings rather than pay them out in dividends. Thus, double taxation hinders the efficient flow of capital. Capital does not flow to those who could employ it most profitably. As a result, the economy is not as productive as it could be and the standard of living for the working class is lower than it could be.

As President Bush explained: "Businesses hire when they grow, and they grow when they invest, and our proposal (to eliminate double taxation) will promote capital formation." He then added "Government spends a lot of money, but it doesn't build factories, it doesn't invest in companies or do the work that makes the economy go. The role of government is not to manage or control the economy from Washington, D.C., but to remove obstacles standing in the way for faster economic growth. That's our role."

By reducing the confiscatory double taxation on investment capital, the President is removing an obstacle to capital formation and increased productivity. This increased productivity will lead to higher wages for American workers and an increased standard of living for all Americans.

Outlook

The double taxation of dividends is interfering with the market's ability to discipline corporate behavior. The elimination of double taxation will put pressure on firms to pay out dividends. Firms can currently use dubious revenue recognition assumptions to inflate earnings without having pressure to pay dividends out of the resulting inflated earnings. The elimination of double taxation of dividends will also lessen the control corporate managers have to invest retained earnings in pet projects, nonsynergenic acquisitions, and perks such as corporate jets. Currently these investments do not receive much attention from shareholders because they are tax deductible and dividends if paid would be taxed at the shareholder level. The result in a less efficient allocation of capital and a resulting lower growth in productivity and standard of living.

In most large corporations, a separation exists between ownership and control. Shares of these corporations are widely dispersed so the managers (who own a relatively small percentage of stock) effectively control the corporation. The goals of the manager-agents and the shareholder-principals are often not aligned. The shareholders are interested in maximizing the value of their shares. Similar to the politicians, corporate managers wish to maximize the amount of funds they have at their disposal and retain their jobs.

It is more prestigious and lucrative (e.g., higher salary and perks) to be a manager of a large growing firm than a smaller slower growing firm. Paying dividends has the effect of reducing firm value and reducing the value of management stock options.

It is easier and less stressful to manage a firm that has a bigger cash cushion and excess reserves than a lean firm that must always be fearful of the capital markets. Because corporate managers have more information regarding their firm than do market participants, a situation of asymmetric information exists. Consequently, in an effort to reduce this information asymmetry, each time a firm issues fresh securities, investment banks, auditors, lawyers and other market professionals parties must perform due diligence and thoroughly examine and analyze the firm issuing the securities. Although it helps to reduce agency costs, corporate management does not enjoy this increased scrutiny. To avoid this scenario, corporate managers would rather retain money in their firm than pay dividends. Paying dividends increases the probably that the firm will be required to tap external markets for additional funding.

The bottom line is that many corporate managers will privately fight the elimination of double taxation in an effort to avoid the resulting pressure to pay dividends. This makes it is unlikely that the proposal to eliminate the double taxation of dividends will be enacted into law.