US will reap dividends by ending double taxation- 10th January 2003

Burton Malkiel - Australian Financial Review

The firestorm of criticism that greeted President George Bush's proposal to eliminate the income taxes individuals pay on dividends was fierce - and predictable. Critics have attacked the plan for favouring the wealthy without any beneficial effect on economic activity. But the complaints obscure many real advantages.

The President's proposal would have important long-term benefits. It will eliminate the tax-induced incentives that make corporations adopt overly leveraged capital structures and that contribute to a misallocation of corporate resources. It will boost stock prices, improve credit equity and strengthen corporate governance. The proposal is worthwhile because it will stimulate the economy and have important effects on long-run efficiency.

The present system has had two undesirable effects. First, it has encouraged a dangerous build-up of debt at the expense of equity financing. Because interest is tax-deductible to businesses in the United States, the cost of debt financing is made artificially low relative to equity financing, and firms are encouraged to adopt a leveraged capital structure.

High debt levels make the economy less stable. Any protracted weakness in economic activity can turn a heavy debt burden into a killing one. High debt levels have been associated with many of the large bankruptcies in the past two years. While interest rates today are at 40-year lows, risk spreads in the corporate bond market are at 40-year highs.

Second, the tax system has encouraged a dramatic change in corporate dividend behaviour. To the extent that stocks are held outside of tax-advantaged retirement plans, dividends are taxed at regular income-tax rates while capital gains are taxed at much lower rates if realised. More important, the tax on unrealised capital gains is deferred and can be eliminated completely if stocks are bequeathed to one's heirs. Small wonder that stockholders in companies such as Cisco recently voted 10 to one against the company paying cash dividends.

The bias against dividends has also been influenced by employee stock-option programs. The optionee does not receive credit for dividends paid but does benefit if funds are used to buy back shares creating capital gains. Fewer companies today pay dividends and those that do so have been increasing their dividends far more slowly. Dividend payout ratios - the proportion of earnings paid out in dividends - have fallen from close to 60 per cent in the 1960s to just over 30 per cent today. The percentage of large nonfinancial firms paying dividends has fallen from over 80 per cent in the early 1960s to just over 50 per cent today.

This shift has created distortions: the unfavourable treatment of dividends encourages a misallocation of capital by favouring retained earnings over cash payouts. If corporate earnings are retained, they are taxed only once. Thus, the tax laws encourage corporate managements to retain earnings. Particularly during the ebullient markets of the late 1990s, managers reinvested earnings in acquisitions with questionable pay-offs. It is, I suspect, not accidental that most of the major recent corporate scandals, and some of the most glaring instances of misallocation of resources, occurred in companies that paid no dividends. The payment of dividends imposes a discipline on management to ensure that corporate resources are spent only on projects that can pass an external market test.

By eliminating the personal income tax on dividends, the tax system will become more even-handed in the treatment of debt and equity. While debt financing will retain the advantage of allowing interest to be deducted from corporate taxes, interest received will continue to be fully taxable when held outside of tax-advantaged retirement plans. Dividend payments will come after the payment of corporate taxes but the recipients will not be taxed. Assuming an average marginal corporate and individual tax rate of, say, 35 per cent, debt and equity would be treated in roughly an equivalent fashion.


In an environment where reported earnings are viewed with some degree of scepticism, cash dividends will provide a very strong signal to investors of true financial strength and of the credibility of earnings reports. Even John Chambers of Cisco has made clear that Cisco would reconsider its "no dividend" policy if the tax law were changed.

Other advantages would follow as well. Firms would be encouraged to compensate managers with stock grants rather than options and the interests of shareholders and managers could be brought even closer together.

The encouragement of larger dividend payments would signal that managers were willing to let shareholders participate in decisions regarding corporate investment. It would also give shareholders a degree of confidence in the future distribution of cash flows.

My guess is that eliminating the double taxation of dividends would lead to a powerful rally in stock prices and would do much to lift the penumbra of uncertainty that has bedevilled consumers and corporate managers. The US is one of the few countries in the world where dividends are taxed at both the corporate and the individual level.


In the longer run, the effect on corporations and the economy will be unambiguously beneficial.


Burton Malkiel is a professor of economics at Princeton University and is the author of A Random Walk Down Wall Street.


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