Politics & Policy

Scrap The Double Tax

Dividends have consequences — and they're all good.

The president reached the further boundaries of political daring with his proposal to scrap the double tax on dividends. His plan is revolutionary in its implications. The Left, of course, is in full howl against the proposal, foaming at the prospect of the rich wallowing in “unearned” income. Let them tub thump.

Proponents of the president’s tax-reform package should push back hard by arguing that the proposal will improve investor returns, check corporate malfeasance, improve capital allocation across the economy, and lower the cost of capital precisely when the country needs to encourage capital formation.

Improve investor returns. How important are dividends to investors? From 1927 to 2001, investor returns in the S&P 500 Index averaged 10.7% per year, 6.1% from capital gains and 4.6% from dividend payments. But today the dividend yield on the S&P 500 approximates 2%, less than half the historical average. Why? Do the math. Today, when dividends are paid to a taxable account, a corporation pays tax on the income that generated the dividend, and the investor pays tax on the cash received. In rough terms, each dollar distributed results in only 35 cents in the investor’s pocket (or even less depending on state and local taxes). This double-grab by the government (or triple or quadruple grab depending on the local jurisdiction) is akin to being subject to a withholding tax on one’s salary and additional taxes at the ATM.

Yes, a substantial amount of dividend income is distributed to tax-advantaged accounts (IRAs, 401(k)s), but the tax disadvantage of dividends has been clear. And investors have behaved accordingly. To get around the tax, investors and managements are encouraged to keep cash in companies, the shareholder happy to avoid the tax and earn a return purely from capital gains, and management happy to preserve an extra pile of cash within the business. This arrangement works in a rising market. But a three-year market crackup has destroyed equity values. Wider spread use of dividends would have mitigated the carnage. Last year, the 350 companies on the S&P 500 that pay dividends fell an average of 13.3% compared to a 30.3% average decline for non-payers.

In addition to limiting the downside, the president’s proposal will increase the value of dividend-paying assets because of the resulting increase in the after-tax (that is, non-taxed) return. John Rutledge, who runs an eponymous investment firm, writes in Forbes that the president’s plan could increase S&P market values by 8.5%, an increase of just under $800 billion, with the biggest increase in industrials ($255 billion), consumer discretionary ($202 billion), telecom ($132 billion), and health care ($108 billion).

Check corporate malfeasance. Only recently did we discover that a small number of managements engaged in the wholesale manufacture of fictional accounting, some reaping dirty money as they dumped inflated stock on unsuspecting investors. Who should check such managerial piggery? Shareholders, of course. The problem is that shareholder control is attenuated to the point of near irrelevance as investors dart in and out of stocks, performing little due diligence and dumping holdings as soon as the market challenges an ill-informed investment thesis.

One benefit of such investors (or speculators) is that they provide liquidity to the market. What they do not provide, however, is a long-term owner mentality to a company’s shareholder base. How does a company get owner-investors instead of dump-’n’-runners? One way is to pay them cash, through dividends. Morgan Stanley reports that companies that pay dividends have shareholder turnover that is half that of companies that do not pay dividends. Why? Because dividends pay people to sit and own and monitor their investment. Think of it as Samuel Johnson’s adage retooled: dividends concentrate the investor mind.

Dividends also help investors cut through the morass of detail in a company’s reported results. Reported results reflect accounting rules and estimations, not cash results. They are vulnerable to manipulation. Tricks that goose accounting results are more difficult to maintain, however, when a company is required to distribute cash to shareholders. Either a company has the cash or it doesn’t. With the cash demands of a dividend, managerial manipulations are less likely to go undiscovered.

Improve capital investments across the economy. Dividends discipline managers to allocate cash resources more effectively because they reduce cash available for lower-returning projects, a scarcity that compels a higher standard of scrutiny of each project. At some point, cash to be invested in a marginal project is better given to shareholders to invest in more profitable opportunities.

But the destruction of $0.65 of every dollar distributed to taxable accounts creates a warped incentive: sub-optimal projects are curbed by dividends only so long as the likely range of outcomes is, at worst, the destruction of value that exceeds that caused by double taxation. Thus, tax distortion prevents dividends from effectively competing against sub-optimal projects for the last investment dollar. The result is that managements are not disciplined by dividends when they want to make Hail Mary investments — better to invest in marginal projects that have a chance of profitability than to give the bulk of the money to Uncle Sam through the dividend double tax.

Increase capital formation and lower the cost of capital. The president’s dividend tax cut would put tens of billions dollars of dividend taxes back into the pockets of America’s investors. Most of this capital would be reinvested immediately, thereby increasing equity values.

Simply put, removing the double tax would immediately lower financing costs as investors bid up dividend paying assets, lowering the cost of equity capital. But there is a longer-term implication as well. Equities are valued at multiples of future streams of earnings per share. Dividends may signal to the investor that the future streams he is paying for are real and not gamed. This implies lower risk and justifies a higher multiple to be paid for earnings projections. The resulting higher equity values would not just help shareholders — they would also lower risks for debt holders. In short, the risk at each level of a capital structure should decrease, and lower risk means lower risk premiums. That is, investors should charge a lower cost for use of their capital because of the reduced risk they would be asked to assume.

No one argues that dividends are a replacement for character, judgement, and prudence. They will not prevent what befalls those swept in the market’s ebb and flow of greed and panic. But they do mitigate value destruction during market declines. They help check manipulation of earnings. They help curb over investment. They promote capital formation. They reduce the cost of capital.

So let’s be clear as to why the Left opposes the president’s plan. It’s not the deficit. If it was they would curb profligate spending. It’s not concern about the need to stimulate the economy. If it was they would support tax policies that promote capital formation. When you cut through all of the rhetoric, you come to this: The president’s plan violates, as Voltaire observed, the general art of government, which consists in taking as much money as possible from one class of citizens and giving it to another.

— Christopher E. Baldwin writes from Manhattan. He can be reached at christopherebaldwin@hotmail.com.


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