In 1980, the year before Ronald Reagan took office, the maximum tax rates were 46 per cent on corporate income and 70 per cent on personal income. There was also, as there is now, a very odd dichotomy in the way that taxation treated interest and dividends. To illustrate its consequences in those days, imagine a corporation, its shareholders, and its bondholders all to be in the highest income-tax bracket. If the corporation earned one additional dollar of income and the full impact of that dollar was directed toward dividends, then the corporation was required to pay 46 cents additional corporate tax. This left the corporation 54 cents to distribute to its shareholders in the form of dividends. The tax liability of the shareholders rose by 37.8 cents (70 per cent of 54 cents), leaving them with a net gain of 16.2 cents. Therefore, the after-tax incentive for shareholders was 16.2 cents.
Suppose, however, that the corporation earned one additional dollar and used it to pay bondholders additional interest. There would then have been no additional corporate tax liability. For interest payments were fully deductible against corporate income in 1980, as they are today. The net effect on corporate taxable income was nought. Bondholders thus received one full dollar of pre-tax income, whereas shareholders received only 54 cents. Assuming that these bondholders are in the highest tax bracket, their additional personal-income-tax liability would be 70 cents—leaving them with 30 cents versus 16.2 cents for shareholders (Table 1, Rows 5 and 6).
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