The Washington Times

I published in Policy Review’s June-July edition an article by a California portfolio manager, Steve Stein, called “Taxes, Dividends, and Distortions.” It was a rather brilliant discussion of the drastic decline [to the point of near-demise] of the practice of corporations paying annual dividends to their shareholders. Where once dividends were the rule and retained earnings drew the scrutiny, now the opposite is the case.

The reason for this is that when corporations pay dividends, the money is taxed twice – first as corporate income, then as individual income on Schedule B of your itemized return. This creates a huge disincentive. Shareholders don’t demand dividends because they know that the act of paying them increases the government’s take.

Look at it this way [in Mr. Stein’s example]: Let’s say you receive a $1,000 corporate dividend and reinvest the money for 20 years at a 5.5 percent rate of interest. If you first pay a combined federal and state 40 percent tax on the dividend, that means you start off with $600 instead of $1,000, and after 20 years you have $1,716. But if you can invest the full untaxed $1,000, you end up with $2,883.

But suppose the corporation holds on to the $1,000. In order to do just as well with the money as you would do if you had to pay tax on it, the corporation wouldn’t need to earn a 5.5 percent rate of return, but a 4.3 percent rate. Therefore, you’re not clamoring for the dividend [on the assumption that the premium will be reflected in the stock price in the long run].

This has the effect of dissociating shareholders from company earnings. It also encourages potentially dubious investment strategies for retained earnings by management [tech firms whose stock is trading at inflated prices buying other tech companies at inflated prices because that is the industry they know best]; dubious corporate stock buybacks whose principal beneficiaries may be not shareholders in general but stock option holders [i.e., management] in particular; and the creation of dubious hybrid instruments that turn corporate payouts to individuals into tax-deductible interest rather than taxable dividends.

Now, here’s the problem: How on earth do you make a political case for ending the double taxation of corporate dividends [or at least substantially mitigating its effect] without running into a buzz saw? An individual tax cut that gets bigger based on the size of your portfolio: Why does this not sound like something Dick Gephardt will like? I have heard conservatives argue that taxing the same dollar twice is unfair. OK. But in the universal scheme of unfairness, the urgency of rectifying this one in particular does not exactly sing out to people. So I published Mr. Stein’s piece mainly in the hope of getting a longer-term discussion going.

Except that, viewed in the context of the corporate scandals, the distortions introduced aren’t a byproduct of the injustice of taxing twice. The distortions themselves are the problem, and an urgent one that can really only be fixed in one way.

If there is a common trait to the rash of corporate scandal, it is shenanigans undertaken for the purpose of being able to state larger-than-life earnings. It’s time to ask whether a central component of this isn’t the increased remove from earnings at which shareholders find themselves.

In the first place, there is the raw question of having the money: If you’re sending a significant chunk of annual earnings to shareholders, you need it on hand. This would seem to leave less room for multibillion-dollar fraud. Second, management will tend to be held more accountable for the returns on retained earnings if management doesn’t enjoy the luxury of, in effect, a tax code-created subsidy in investing them. Third, the structure-warping incentives to recast payments as tax-deductible debt, once removed, will likely yield more transparent corporate books.

Again, the problem isn’t that the rich are taxed twice. We should all have such problems. The problem is that when shareholders are artificially separated from earnings, the temptations for management laxity or misbehavior can become too great.

Oddly, it’s the small shareholder, the one with an IRA or 401[k], who loses the most under the current scheme. He wouldn’t pay tax on most dividends anyway, since they’d be paid into tax-free accounts. But he doesn’t get a dividend at all, because it makes little sense for corporations to pay them when they disadvantage the bigger investor. We have a tax code that locks up these earnings in the corporate piggy bank, on the theory that they will eventually be reflected in stock prices, without taking into account the potential they also have for distorting stock prices.

We’ve democratized capital with widespread stock ownership; it may be time to democratize earnings by removing the impediments to people seeing their share. It’s also an excellent way to see how much is really in the safe. All of which is now very much on the mind of the Bush administration.