As stock markets continue their roller-coaster ride, the search continues for ideas that can help restore investor confidence while boosting economic growth. Jeremy Siegel, author of the best-selling book “Stocks for the Long Run,” and Andrew Metrick – both finance professors at Wharton – with Paul Gompers, a finance professor at Harvard, argue that a simple solution would be to eliminate one of the most detrimental taxes in the U.S. economy – the corporate dividend tax. Siegel, Metrick and Gompers made the case for making corporate dividends tax deductible in a recent article in the Wall Street Journal. A slightly different version of their article appears below:
On August 13, 2002, George W. Bush hosted the President’s Economic Forum at Baylor University with the stated goal to “foster discussion of new ideas for economic growth.” On top of his agenda should be the elimination of one of the most detrimental taxes in our economy – the corporate dividend tax. The sharp decline in cash dividends on common stocks over the past decade has been the major cause of the lack of earnings credibility and the woes bedeviling the stock market.
The Wall Street Journal, in its August 6 editorial, “Bring Back Dividends,” correctly identified tax policy as the source of this problem and bravely called for both the deductibility of dividends at the corporate level and the abolition of dividend taxes at the personal level. But that proposal swings the pendulum too far in favor of dividends. Since interest payments to bondholders are treated as taxable income, exempting dividends from the income tax would give equity an unfair advantage. We believe that solely granting dividends deductibility from the corporate income tax, which puts debt and equity on completely equal footing, will achieve the same goals while costing the Treasury far less money.
Few recognize how pernicious the double taxation of dividends is. Since interest costs, but not dividend payments, are deductible, management is inclined to raise an excessive level of debt and to retain earnings, since paying dividends currently confers no tax benefit. These retained earnings are hopefully transformed into capital gains for both shareholders and option holders, particularly for top-level, option-laden management.
Over the past decade, the proliferation of option-based compensation schemes and an increasingly tax-sensitive shareholder base caused capital gains and not dividends to become the preferred source of shareholder return. When the earnings are of unquestionably high quality and are being invested profitably, the shift to tax-favored capital gains rewards stockholders. But the revelations at Enron, WorldCom and other firms have shown that creative legal accounting and often outright fraud has impaired our ability to use the earnings reported by management as yardsticks for judging value.
How would the deductibility of dividends “fix” these problems? If dividends were a deductible expense, firms would be strongly motivated to pay out all their profits as dividends, since retained earnings would be subject to the corporate tax. Firms that did not pay dividends would be viewed unfavorably by investors who feared that the earnings are inflated and that the cash does not exist. The payment of cash dividends would therefore add significant credibility to management’s earnings reports.
Allowing dividend deductibility would also eliminate the incentive for management to take on large amounts of debt and risk bankruptcy just to gain the deduction for interest costs. Furthermore stock options would become much less valuable under our proposal since most of the stock return would be paid in dividends and not through capital gains. This will lead management to grant shares instead of options to employees, which will lead to more accurate income statements and a better alignment of management with shareholders interests.
But the benefits do not stop here. Our proposal would also halt the increasing number of firms who seek to re-incorporate outside the US in such tax havens as Bermuda. Corporations that have proposed moving their headquarters offshore argue that they can shield foreign-earned income from an additional layer of taxation in the United States, with purported annual tax savings of tens of millions of dollars. These relocations have rightfully raised the ire of taxpayers and Congress and raise serious problems about corporate governance. But under our proposal, firms could avoid tax on such foreign-earned income just by paying out these profits as dividends and thus the incentive to relocate is sharply reduced.
Furthermore, our proposal would go a long way to reducing the risks associated with the over-allocation of company stock in employee 401 (k) portfolio portfolios, such as occurred with Enron. A major reason that management provides such lavish incentives for employees to invest in company stock is that firms receive a tax deduction for dividends paid on stock held in 401(k) plans. If all dividends were deductible, there would be much less incentive for companies to issue their own stock to employees, a practice that leads to unbalanced and risky portfolios.
We can already hear the objections of three interest groups to our proposals: young and fast-growing firms who need retained earnings to invest, investors who don’t want to receive taxable dividends, and budget hawks that believe that this proposal will be too costly to the Treasury. We believe that all these objections hold little merit.
Young and fast-growing firms, such as those in the technology sector, argue that they need retained earnings to grow. But our proposal would not hamper them. Most start-up firms make little or no profits, so they would be able to keep all their cash flow without tax. Firms with profits should pay them out, but they can easily and automatically access the capital markets for more funds. We envision dividend reinvestment plans (DRIPs), where stockholders who wish to reinvest their dividends into new shares could do what many investors already do now with mutual funds (of course, such reinvested dividends would still be subject to the personal income tax). Moreover, market access through rights and secondary offerings would become a more common source of raising capital. And of course there would be still be access to all the standard bank and credit markets.
Corporate managers might argue that going to the equity markets to raise funds is both expensive and might suggest that managers believe their stock price is overvalued. While this may be true in today’s environment, if our proposal were adopted, raising equity would not carry such a stigma. The tremendous increase in dividend payouts would provide investors with billions of dollars of extra dividends to reinvest, and firms with good investment prospects would find easy access to additional capital. Moreover, by continually going to the equity markets, investment decisions could be more easily scrutinized. Managers would have no choice but to release greater information about their proposed expansion strategies, giving investors the opportunity to judge for themselves the merit of those plans.
The loss of tax revenue to the Treasury should not be serious. In 2001 corporations paid taxes of $151 billion, or 7.6% of the federal budget. If the deductibility of dividends were enacted, a large part of that revenue would disappear as firms reduce their tax by paying dividends. But the Treasury would recoup some of the loss of corporate tax revenue with the increase in personal taxes on dividends. Furthermore, if this proposal is adopted, we advocate that all other corporate tax credits, which have averaged about $50 billion annually, be eliminated. There is no need to lavish tax loopholes on firms once we give corporations the option of avoiding tax by paying profits to shareholders. The elimination of these loopholes would not only simplify the corporate tax but should sharply reduce corporate influence-peddling and lessen some of the all-too-cozy ties between politicians and big business.
Certainly the higher level of dividends that would follow from our proposal means that individual investors would pay higher taxes on dividend income. But with the reduction in corporate taxes, firms’ after-tax earnings will increase about 50%, so management will be able to increase their payouts sufficiently to offset the extra dividend tax. Finally, in order for our proposal not to disadvantage any current employee who holds options, we would support a one-time adjustment in option terms when the dividend policy is changed.
Changing our Byzantine tax system is never easy, but if President Bush and Congress are serious about implementing effective reforms to restore faith in our corporate system and financial markets, our simple proposal will do more than all the legislative acts, SEC jawboning, and CEO certifications rolled together. When investors say “Show me the money” management will happily do so with a smile on their faces. This is a reform that Washington must pass.