Benefits from eliminating the double-taxation of dividends - Forum on Emerging Issues

Business Economics, Jan, 2003 by Richard B. Berner

Until recently, simply owning stocks returned sixteen percent annually, investors cared little about dividends, and many companies avoided issuing them. The irregular slide in the dividend-payout ratio from fifty-five percent to sixty percent in the 1960s to only thirty percent to thirty-five percent today bears witness to that trend. Partly, that is because of the tax treatment of dividends compared with that of capital gains: corporate income is taxed once at the corporate level--thus diminishing what is available to be paid out to shareholders--and again to the shareholder on receipt of a dividend.

To be sure, the U.S. tax system is actually far more complex, so some corporate income is taxed twice, some once, and some not at all. (1) And factors other than taxes influence dividend policies. Nonetheless, tax incentives meant that both companies and shareholders preferred share buybacks--effectively taxed at the preferential capital gains rate--to dividends. And the resulting tax advantage of debt over equity finance also contributed to dividends' unpopularity. In the bull market, investors blessed managers who were reinvesting and boosting returns apparently to record levels through organic growth or acquisitions, often by levering the balance sheet, instead of paying dividends. (2)

That is changing--and for the better, in my opinion--as investors now see that leverage went to excess and want the right to make their own reinvestment decisions. As a result, dividends are becoming fashionable again. For example, in the second quarter, dividends for the S&P 500 universe of companies rose by 7.8 percent from a year ago, and the payout ratio may now be stabilizing. In the bear market, moreover, investors have rediscovered that dividends cushion returns: companies that paid dividends in the first nine months of 2002 outperformed those paying no dividend by 2,250 basis points. But policy can play a constructive role to further the move back to dividends. In fact, I believe that changing the tax treatment of dividends would have several important benefits for the economy and for corporate governance. Here's why.

The unfavorable tax treatment of dividends is ancient, as is the discussion of tax reform to change it. Experts have long recognized that the tax code contains incentives to misallocate capital, promoting leverage and the use of retained earnings to finance investment, and that it encourages share repurchases at the expense of dividends. But now the discussion is more than just academic. Big tax distortions are relatively new, as Congress effectively raised personal taxes on dividends three times in the 1990s. Lawmakers increased top tax rates with the Omnibus Budget Reconciliation Acts of 1990 and 1993. Then with the Taxpayer Relief Act of 1997 they effectively increased dividend taxation again by reducing the top tax rate on long-term capital gains from twenty-eight percent to twenty percent--just after Fed Chairman Greenspan began to muse about irrational exuberance. (Note that the Tax Reform Act of 1986 effectively reduced the top tax rate on dividends by reducing the top marginal tax rate from fifty perc ent to twenty-eight percent, and that the dividend-payout ratio subsequently jumped.) More important, in my view, the interplay between the bull market and the 1997 reduction in the top capital gains tax rate changed the game, and especially expanded incentives to avoid dividends and increase share buybacks.

More ominously, I think that interplay also gave managers scant incentive to create shareholder value, and it eroded corporate governance. Instead of paying dividends, managers now had even stronger incentives to embrace leverage and reinvest earnings in acquisitions with questionable economics, often in an effort to create the appearance of growth. Small wonder that the pace of acquisitions soared soon after, with domestic merger and acquisition volume doubling in the spring of 1998 to over $200 billion. Recent studies suggest that few of those mergers have truly paid off for shareholders. And most troubling of all, some managers saw incentives to manufacture earnings in order to support share prices.

Finally, in the bull market, this tax-cum-stook-market interplay also encouraged managers, especially at technology and other growth firms, to issue massive numbers of nonqualified stock options. Despite potential dilution, shareholders didn't object: share prices at growth companies were awarded a premium, rewarding shareholders and optionees alike. And because corporations can deduct the difference between the strike and exercise prices when employees exercise options, growth companies used options to reduce their future taxes and turbocharge reported earnings. John Graham of Duke University estimates that deductions for the exercise of nonqualified employee stock options enabled Nasdaq 100 companies in 2000 to reduce their tax liabilities by $100 billion, and to cut their effective marginal tax rate from thirty percent to four percent. Such calculations help explain why growth companies eschew dividends: they prefer to use cash to buy back shares--not just to distribute returns to shareholders, but to fund option programs to avoid diluting shareholders. Unfortunately, as foreshadowed by research by Nellie Liang at the Federal Reserve, the pace of buy-backs to fund option programs proved unsustainable. And for some managers, the temptation to manipulate earnings to keep options in the money proved irresistible.