President Bush’s proposal to reduce taxes on corporate dividends is being attacked by Democrats as another give-away to the rich. But not too many years ago it was Democrats who were in favor of this policy and Republicans who were against it. In 1976, Democrat Jimmy Carter made elimination of the double taxation of corporate profits a key campaign theme. “We presently tax corporate income when it’s earned and we also tax dividends to shareholders,” he said. “I would favor taxing income only once,” Carter told Fortune. When President Carter took office in 1977, he reiterated his goal of taxing corporate income only once and had the Treasury Department examine the issue. He received support from many voices of liberalism in this effort. For example, Americans for Democratic Action called for abolition of the corporate income tax at its convention in May. On September 11, the New York Times editorialized in favor of this action. Unfortunately, Carter failed to include any proposal for reducing or eliminating double taxation in his 1978 tax reform plan. The reason, interestingly, appears to have been opposition from the Republican-leaning corporate community. According to an article by Robert Samuelson in the National Journal in September 1977, businesses basically killed the idea. According to Samuelson, corporate executives suddenly had a lot of problems with the idea of eliminating double taxation once confronted with its possible reality. Some worried about increased pressure to pay out dividends. This especially concerned small businesses that normally don’t pay dividends. Executives also feared a loss of control over retained earnings, which they could invest as they chose. And they saw many specific tax breaks as better for them. Another reason, I have always believed, is that the corporate income tax acts as a kind of shield protecting corporate executives from shareholders. It allows them to pay themselves inflated salaries and waste shareholder’s profits on expensive perks and investments of dubious value. Since such things are deductible business expenses, shareholders are fooled into thinking that they are not costing them anything. Without such deductibility, it would be harder for executives to justify their behavior. Academic research supports this analysis. Writing in the Yale Law Journal, legal scholars Jennifer Arlen and Deborah Weiss argue that the corporate tax forces shareholders to go along with the wishes of corporate managers even if they don’t agree with them. Double taxation encourages companies to retain earnings rather than pay dividends. So even if managers make bad investments and shareholders have better investment opportunities, it still pays for shareholders to support retained earnings and low dividends with double taxation. Another widely commented-upon result of double taxation is that it encourages companies to raise capital through debt rather than equity. That is because interest payments are tax deductible, whereas dividends are not. The result is that companies become heavily leveraged, making capital less available to small businesses and new startups. The overall impact on the economy is to reduce the rate of return on corporate capital, which slows economic growth. Big established companies have easy access to capital through the bond market and retained earnings, while being protected from potential competitors because the latter cannot raise capital or only at much higher cost. A tax cut on dividends, as President Bush proposes, should raise the value of companies paying dividends. That is because the tax is now capitalized into the price of stock. Thus lowering the tax is equivalent to an increase in profits. Although the tax capitalization thesis is controversial among economists, the latest research strongly supports it. Indeed, Council of Economic Advisers Chairman Glenn Hubbard is the author of much of this research, while a professor at Columbia. Economist John Rutledge estimates that the complete elimination of taxes on dividends would raise the Standard and Poor’s 900 index by 8.5% or $800 billion. Principal beneficiaries would be companies with high dividend payout rates and low debt. However, as managers alter business strategies by reducing debt and raising both equity and dividends, other companies will also benefit. This estimate is consistent with the experience of New Zealand, which completely abolished double taxation of corporate income in 1988. According to a recent article in the Journal of Business Finance and Accounting, the result was that low-debt firms gained significantly while high-debt firms saw their stock prices fall. However, as time went by, debt levels at New Zealand companies fell across the board. President Bush is right to try and relieve the double taxation and over-taxation of corporate income. Not only will it increase the economy’s long-term growth potential, but could provide short-run stimulus by boosting the stock market.
Liberals Once favored abolition of the dividend tax, but now reject Bushs proposal to eliminate this form of double taxation, says Bruce Bartlett.