Should We End the Double Taxation on Dividends?

By Bob Marshalla
February 26, 2003

President Bush wants to end the double taxation on dividends. Is this a good thing? And will it make much of a difference? Well, it depends on what we mean by the questions. Good for what? And in what area will it make much of a difference?

Ø      If the issue is one of jump starting the macroeconomy and propelling it out of its doldrums, the answers are no to both questions. Eliminating taxes on dividends probably won’t have much of any impact on the current state of the macroeconomy, and will just worsen the current budget deficit.

Ø      If the issue is one of social justice regarding income distribution, the answer depends on your own social and political philosophy. Certainly those who pay the most taxes on dividends (i.e., the wealthier taxpayers) will get the most immediate benefits. It’s up to you to judge whether that is good or bad. But it’s not that easy, because there would also be significant longer term and indirect effects whose incidence by demographic group would be very complicated to trace. However, this is not an issue I wish to address here.

Ø      Would it be good for the stock market? You betcha! Even if stock prices did not increase at all, the after tax value of holding stocks would increase, and by more than most people seem to think. Many people don’t realize that historically almost half of the total return from holding large cap U.S. stocks has come from dividends. While the dividend rate on the S&P 500 is currently only about 1.4%, this would likely increase significantly if the double taxation of dividends was eliminated. Further, if the accounting board changes GAAP to require that stock options be expensed (as they should be), there would be even more reason to shift towards paying dividends. (When stock options are used extensively, management has incentives to buy back stock or retain earnings rather than pay dividends, in order to ensure that investor returns are realized via stock price appreciation rather than cash payouts.)  

But lower taxes wouldn’t be the only benefit to stock investors. It should be easy to see why the prices of dividend paying stocks should increase. All else equal, the relative value of owning stocks versus bonds, real estate or any other asset class, would be shifted in favor of stocks if the personal taxation of stock dividends was eliminated. Of course, owners of these other asset classes should beware, since their values may decline, at least relative to stocks.

In summary, eliminating double taxation of dividends would increase the returns for stock investors both by making the after tax value of dividends greater and by causing at least a one time bump up in stock prices relative to other asset classes.  This is quite clearly a good thing for stock investors in the immediate time frame.

Ø      Actually, there is another question that in my mind is more important than any of those addressed so far, and that is, would elimination of personal taxes on dividends be a good thing for the functioning of companies, industries and markets in the long run?  I.e., is it good fundamental microeconomic policy? This is a structural economic question with potentially larger and more lasting impacts that any of the others, and is therefore the one I find most interesting. In my opinion, the proposed policy would most definitely be a very good thing in this dimension

The crux of the problem is that double taxation of dividends provides such a strong incentive against paying out dividends that many companies end up allocating their earnings to wasteful and inefficient uses. To illustrate, currently if a company designates $1 of pre-tax earnings for dividends, a high income, taxable investor in California will wind up with only about 34 cents of value after payment of corporate and personal income taxes at the federal and state levels. But if the company retains the earnings and uses them for other purposes, it will have about 62 cents worth of the original dollar at its disposal. This is over 80% more than the shareholder would receive if the company tried to hand over the earnings via dividends. It is not surprising that dividend payout rates have dropped to record lows.

But, you may ask, aren’t retained earnings the engine of growth for American companies? How will companies afford to grow if they don’t retain as much of their earnings as possible?  It is true that reinvesting earnings in its own business is generally a good thing for a company, sometimes even essential for its long-term viability. But this is true only to a point. The reinvestment of earnings is beneficial to the shareholder only so long as the return on the reinvestment can be shown to be greater than the company’s cost of capital. The company’s cost of capital is essentially the rate of return a rational investor would demand or expect to receive in order to induce him or her to allocate investment dollars there rather than to some other alternative. The cost of capital for a given company depends on the company’s capital structure (debt/equity split, bond ratings, etc.) and its equity market risk or volatility characteristics. Morningstar has recently estimated that the cost of capital for most large cap U.S. companies is in the range of 8% to 14%[1].

Companies these days simply tend to reinvest more dollars than can be profitably put to work[2]. Perhaps the first “slice” of re-investment earns well over the company’s cost of capital, but as they add more and more “slices” of investment, they get down to less and less attractive ventures or activities.

The double taxation of dividends is not the only reason companies often overspend their resources. Another is that management has a built in bias for growth. Bigger companies and bigger operations make for more powerful executives and higher levels of compensation. But what is ignored is the fact that growth of company size in and of itself is not necessarily good for the shareholders. Only profitable growth is. If earnings per share don’t ultimately increase along with revenues and market share, then the growth has no value or even negative value for the shareholders of the company. So double taxation of dividends just adds an additional excuse for many companies to seek growth that adds little to shareholder returns.  

Re-investment in the company’s own operations is not the only use for retained earnings. Other common uses include mergers and acquisitions, stock buybacks and simply holding the assets in cash or marketable securities. But as in the case of internal re-investment, all of these uses tend to be overdone by many companies. And, similarly, the double taxation of dividends is at least partially to blame.

The situation with using retained earnings for mergers and acquisitions is much the same as for reinvestment in internal operations, though perhaps even worse. Companies tend to overpay for M&A’s due to the built in bias for growth and delusions of grandeur, while under-estimating the true difficulties of achieving the hoped for synergies of the mergers. I think it is fair to say that most large-scale mergers have clearly failed to live up to their promise. And recent accounting changes that eliminate the regular amortization of good will only further disguise the true costs of mergers.

Retaining excess cash is another often overlooked misallocation of capital. Certainly maintaining a healthy level of liquid assets for working capital and as a cushion against hard times is sound financial policy, but as for the other uses of retained earnings, many companies take it too far. Once the working capital and rainy day purposes have been satisfied, keeping more dollars “in the bank” is just a waste of shareholder wealth. A company’s liquid assets certainly don’t earn anything near their cost of capital. A well known example is Microsoft, which holds nearly $40 billion in liquid assets! Does anyone think this represents an efficient use of shareholder assets?

Another use of retained earnings is buying back company shares. In economic effect this is the closest thing to paying out dividends, and it has increasingly been the alternative of choice. Avoiding double taxation of dividends is often the explicitly stated reason for preferring share buybacks. However, there are negatives to a share buyback. For one, it worsens the balance sheet (by increasing the debt per remaining share). Second, you can’t spend a share buyback like you can a dividend. To enjoy the value of a share buyback, the shareholder has to sell his or her shares in the company. This triggers capital gains taxes, as well as leading to greater trading levels and transactions costs. One of the ulterior motives for doing share buybacks rather than dividends is the pervasive use of executive stock options.  Share buybacks generate returns via stock price increases, whereas dividends generate returns via cash payouts. If dividends were no longer taxed after payout, management’s motives with respect to option holders versus the shareholders at large would be rendered more transparent than they are today.

In summary, the biggest problem with the double taxation of dividends is that it induces companies to retain more earnings than can be profitably invested, and thereby causes inefficient allocation of capital resources. Whenever assets cannot be invested so as to generate returns greater than a company’s cost of capital, our economy would be better off if the assets were simply returned to investors so they can select the next best use for them. Removing the double taxation of dividends will at least partially level the playing field as to the incentives companies face for how to use the earnings they generate.

Removing the double taxation of dividends would have little to do with solving our current day macroeconomic problems. On the other hand it should provide at least a one time boost for the stock market. But most important, I expect it would have a highly beneficial long term effect on the functioning of companies and capital markets.