Are Dividends Really as Taxing as Firms Claim?
By Beverly Goodman
Senior Writer
11/22/2002 10:41 AM EST
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Eliminating the double taxation of dividends has become a rallying cry of many
investors, politicians and pundits who think it's the surest route to everything from
economic recovery to market reform.
Like all catchphrases, though, the term is slightly misleading and shrouds a much
larger, complex issue.
The term comes from the fact that corporate profitability, when distributed as
dividends, is taxed once at the corporate level and again at the individual level. Public
companies generally pay a 35% tax on their profits. If they opt to distribute some of
the remaining profit in the form of dividends, the individual receiving the dividend
also pays ordinary income tax on the distribution -- that can be as much as 38.6%.
Let's say a company has a profit of $10 a share it decides to distribute as a dividend.
That $10 is taxed at 35%, which means the company now has $6.50 per share to
distribute. The individual who receives that $6.50 pays ordinary income tax on it -- if
the investor is in the highest tax bracket of 38.6%, that's $2.50 in tax. Now the net
dividend the individual receives is $4. That's a net of $4 on $10 of corporate profit.
Breakdown of Taxes on Dividends
(And yes, you'll still owe that tax if you reinvest the dividends. The reinvested
dividends, though, will increase your cost basis in the shares, which will eventually
mean you'll pay less in capital gains tax when you sell the stock.)
Talk of eliminating the double taxation of dividends has been bouncing around
Congress and Wall Street for a number of years. There are currently at least two bills
in the House that propose "fixing" this issue, and the new Republican Congress that
begins in January will likely include the issue along with a slew of other tax-policy
changes, according to Chris Edwards, director of fiscal policy studies at the right-
leaning Cato Institute.
Spare Change
Clearly, wealthy investors (those in high tax brackets and with a big investments in
dividend-paying stocks) are hit the hardest most immediately. Even so, about half the
dividends distributed escape immediate taxation, according to William Gale, a senior
fellow at the Brookings Institution.
Dividend-paying stocks held in pension funds and other tax-deferred plans such as
401(k)s and IRAs are not taxed when they're paid out. Rather, the dividends (just like
all the other money in those plans) are taxed when the individual withdraws money
from the plan.
But proponents of change argue that eliminating the double taxation will not only
encourage companies to pay out more profits to investors, but that it also heralds a
host of beneficial ramifications, including better behavior among executives and a
more stable stock market.
"There's been a standard economic argument that the recent corporate scandals were
pushed to the edge because the tax code encourages companies to be over-leveraged,"
Edwards says. "Eliminating the double taxation of dividends would encourage
companies to finance themselves with equity rather than debt. They'd have no
incentive to retain earnings, which sometimes means management has too much
money to play with."
Instead of paying out dividends, many cash-rich companies -- such as the two most
oft-cited examples of Cisco Systems (CSCO:Nasdaq - news - commentary - research
- analysis) and Microsoft (MSFT:Nasdaq - news - commentary - research - analysis) -
- hang on to their earnings. Taxes certainly play a role in that decision, but other
reasons also include wanting to keep a "war chest" to finance impending acquisitions
or other costly endeavors; opting to buy back company stock, which benefits
shareholders; and the sense that the company will get a much higher return on the
profits than individual shareholders will.
"Most companies retain their earnings for strategic reasons and business
considerations," says Michael Levin, a corporate tax analyst for RIA, publisher of tax
and accounting information. "Changing the law won't mean they'll all start paying
dividends."
Many growth companies, in the technology sector in particular, are unlikely to ever
pay out dividends, because almost by definition companies that pay dividends are not
growing as fast as they once did.
"Giving out dividends a company is saying that 'we're betting that mom and pop
investor can find a better economic use for this money than we can,'" says James
Cusser, who manages a $1.5 billion bond portfolio for Waddell & Reed. "It's a game
of perception."
Indeed, this week Cisco shareholders voted against a proposal to distribute at least
part of the company's $21.5 billion in cash. CEO John Chambers has repeatedly said
the company prefers to spend its cash on acquisitions and stock buybacks. In what
may have been a not-so-subtle message to Washington, though, Chambers
acknowledged at the shareholders' meeting that "if dividends were certain not to be
double taxed, we would look at it."
For the Good of the Country
The stomach-churning performance of growth stocks is exactly why they should start
paying dividends, Cusser says. "Much of the volatility in the market is because too
many companies don't pay dividends," he says. "Dividends stabilize volatility. It's just
like bonds -- if you have a zero-coupon bond, all your rate of return comes from the
price variation of the bond. It's the most volatile of all bonds." (Zero-coupon bonds
are sold at a deep discount to face value, and mature at face value. Such bonds tend to
be very sensitive to changes in interest rates, since there are no coupon payments to
reduce the impact of interest rates changes.)
Cusser points to the 11 1/4 U.S. Treasuries, which have a face value of $100 but are
currently trading at $165 since the market has placed such a high premium on
Treasuries.
Bonds that pay a coupon, though, generally don't trade at such a high premium or
discount to face value, because investors are placated by the regular coupon (interest)
payments.
The theory bears out in the equity market as well. The 149 companies in the S&P 500
that do not pay a dividend saw their share prices plummet an average of 32.7% year-
to-date as of Oct. 31. The 351 companies that do pay a dividend had an average drop
in share price of just 12.6%. (There are other factors to consider, of course, but the
difference is telling.)
Possible Solutions
There are two principal ways of eliminating this double taxation -- give the
corporations a break or give the individuals a break.
The most popular corporate tax break proposed is to simply exempt from tax any
profit that gets distributed to shareholders. A solution that gives companies an
immediate tax break on the assumption that subsequent effects will benefit the
individual, though, isn't politically viable on its own.
The core of any proposal will likely focus on the individual. The two options being
floated in Congress now both allow for individual investor to exclude a portion of
their dividends from tax. One way of accomplishing that is through a complicated
calculation that would give individuals a tax credit based on the tax the corporation
pays. Such a calculation is scalable, and would get larger in proportion to the size of
the investment.
"The credit idea will die a quick death," predicts Martin Nissenbaum, the national
director of income tax planning for Ernst & Young. "People won't understand how it
works."
Alternatively, Congress can implement a more straightforward exemption; for
instance, simply excluding the first $1,500 in dividends from tax. "The Internal
Revenue Service just changed the rules for how dividends get reported," Nissenbaum
says. "You don't need to fill out the Schedule B if you have $1,500 or less in
dividends. That would be a good cutoff for the exemption."
All these possible solutions, though, will ultimately be evaluated based on how much
they'll cost. As Congress debates a host of tax-policy changes -- including everything
from expanding the benefits of retirement plans to eliminating the estate tax -- the
benefits and cost of eliminating the double taxation of dividends must be weighed
against each of the other tax policy proposals.