TCS Daily

Double Tax Trouble

By Stephen W. Stanton - October 18, 2002 12:00 AM

Few in Congress understand that double taxation amounts to a misguided "sin tax," punishing companies for simply paying dividends. As a result, companies pay fewer dividends than ever. It sounds innocent enough, but the results are staggering. Fortunately one member of Congress from California understands the problem is doing something about it.

But to understand the problem, let's take a closer look at dividends. Many senior citizens depend on dividends to live. In fact, 30% of dividend recipients earn less than $30,000 a year. When dividend yields drop, many seniors must sell their shares to pay bills. During market downturns, more shares must be sold to raise the same amount of cash. The heavy selling depresses share prices, and even companies with healthy earnings cannot protect their investors from losses.

Dividends have decreased because of their unfavorable tax treatment relative to debt payments. When a corporation pays back debt, the interest payments are tax deductible. However, when a company pays dividends, there is no deduction allowed. While the issue sounds simple, a deeper understanding of finance is required to illustrate the magnitude of this distinction.

For example, assume a hypothetical company owns a $300 factory, financed with $200 in equity and $100 in debt. Further, assume the company earned a current year profit of $40 before interest and taxes. If the company pays $10 in interest on its debt, it is deducted, leaving taxable income of $30. This amount is taxed at 35%, regardless of dividend payments, leaving only $19.50 available to shareholders. [$30 x (1-.35) = $19.50]

In this example, bondholders received a return of 10%, while shareholders only received 9.8% ($19.50 dividend / $200 equity = 9.8%) before individual taxes. Since stock is inherently more risky than bonds of the same company, this capital structure is unacceptable to shareholders.

Not surprisingly, the company would probably adjust its capital structure so that it has more debt and less equity, perhaps $200 of the former and $100 of the latter. Assuming the same $40 profit (before interest and taxes) and 10% interest on debt, the company now pays interest of $20, leaving $20 in taxable income. After taxes of $7, dividends of $13 can be paid to shareholders, providing a 13% return on their $100 investment. The return to shareholders is higher that the 10% return to bondholders. As this simplified example shows, double taxation of dividends encourages companies to assume more debt. Managers would rather pay 10% interest on debt than 35% tax on dividends.

So far, so good. But the real problem happens when profits weaken. Debt-heavy capital structures are very precarious, prone to collapse or bankruptcy. When profits (before interest and taxes) drop to $15 a year, the company could easily meet its bills if it only had to pay $10 in interest. But with an added debt burden, it cannot meet a $20 interest obligation. To raise the needed cash, the company must either raise more money or cut costs. Both of these options make a bad situation worse. To raise money, the company usually needs to borrow more or rush to sell off assets. To cut costs, companies lay off workers and cut down on service levels.

In a recession, profits usually weaken for many companies concurrently. Recessions are exacerbated by the layoffs, cost cutting, and emergency asset sales necessary to pay off excessive debt loads. Many companies simply cannot find enough money to service their debt during lean times and are forced into bankruptcy. (2002 saw a record number of bankruptcies.) High unemployment, loan defaults, decreased tax receipts, and government deficits are all part of the self-perpetuating downward spiral triggered by high debt levels encouraged by double taxation of dividends.

Eliminating the double taxation of dividends would incentivize companies to become less reliant on debt. Lower debt burdens reduce the risk of bankruptcy. Perhaps more importantly, lower debt levels reduce the urgency of cost cutting and layoffs in lean economic times. Recessions would not be nearly as deep.

Another unintended consequence of double taxation is market volatility. Because companies are so highly leveraged, the value of equity fluctuates wildly. If a company that is 75% debt financed loses 10% of its enterprise value, the stock drops 40%.

To avoid double taxation, many companies pay no dividends at all. Giants such as Microsoft, Dell, and Berkshire Hathaway avoid paying dividends entirely. This policy increases the volatility of a stock. According to most models, a stock price represents the net present value of discounted future cash flows. Without current dividend payments, all cash flows are expected in the distant future. Therefore, stock prices are increasingly sensitive to changes in interest rates, market conditions, and unexpected developments. This sensitivity works both ways, both exacerbating bear markets and turning bull markets into full-fledged speculative bubbles.

Clearly, double taxation should be scrapped for its deleterious effect on the economy, on senior citizens, on employment, on the equity markets, and on investor confidence. Unfortunately, too many people think dividend tax relief is nothing more than a "tax break for the rich" or even "corporate welfare." Such rhetoric made reform politically untenable.

Luckily, there is hope. Participants at the President's Economic Forum in Waco discussed dividend tax relief. The Bush Administration has kept hope alive, though it has not pursued the measure too vigorously.

Representative Christopher Cox has been much more proactive in fixing the problem of double taxation. He introduced H.R. 5323, the Investor Protection, Market Stabilization, and Tax Fairness Restoration Act of 2002 to "protect taxpaying investors in America's equity markets, promote a greater correlation between earnings and equity prices, and encourage economic growth by eliminating the unfair double taxation of dividends."

The Cox bill provides a credit to shareholders based on the corporate tax paid by the dividend payer. The tax credit cannot exceed an investor's tax liability. In this way, the bill preserves more tax revenue than would be the case if dividends were simply deductible from corporate tax returns. (Large shares of corporate equities are held by pension funds, nonprofit endowments, and retirement accounts that do not benefit from the credit since they do not pay taxes.) Perhaps more importantly, the bill levels the playing field for corporate investors. Tax-preferred pension funds will no longer "crowd out" tax-sensitive investors among dividend paying stocks.

Ask those that protest the Cox bill, what is more important: Soaking the rich out of spite... Or stabilizing the markets, growing the economy, protecting jobs, and providing retirement security to every worker expecting a pension? The upper class, the working class, and the retirees are all on the same side of this issue. Unfortunately, some of them do not know it yet.



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