How Higher Dividend Taxes Reward Bad Behavior

In his State of the Union address, President Obama proposed a significant increase to the federal income tax on dividends that would hike the rate from 20% to 28%.

Including the 35% corporate tax, the 3.8% net investment income tax, and an estimated 8% state tax, that brings the total tax rate payable on dividends to an exorbitant 59%.

[ad#Google Adsense 336×280-IA]Thus, the system as it stands encourages speculation and discourages long-term investing… and I say it’s about time the taxman found another victim.

Corporate dividends are a uniquely disfavored item in the tax code because they’re taxed twice – once when the company earns income, and a second time when the dividend is paid to a recipient.

On the other hand, debt is treated more favorably than equity capital because its interest is tax-deductible.

This combination encourages management to substitute debt for equity and share repurchases for dividends.

Ultimately, this makes the company riskier and disadvantages dividend investors, who are taxed twice on the element of return they value most.

The Modigliani-Miller Theorem, which received a Nobel Prize for economics, says that companies should be indifferent to their financing because leverage correspondingly increases the required return on their equity.

Combined with the tax-deductibility of debt interest, it’s no surprise that finance professors are encouraging companies to leverage up to the eyeballs, taking on all but the last dollar of debt that lands them in bankruptcy.

Furthermore, companies can then use corporate cash or leverage to buy back shares, which incurs no tax liability and reduces the share count. This makes management’s stock options more valuable, but it does nothing for the retail investor, who normally doesn’t have the opportunity to tender his/her shares directly to the company undertaking share repurchases.

Bush’s Botched Attempt

The George W. Bush tax reform of 2003 attempted to alleviate this problem by reducing the tax on dividends. However, as with many things undertaken by the Bush administration, the tax reform got screwed up.

You see, Bush made dividends partly tax-exempt to individual recipients, taxing them at 15%, while still leaving them fully taxable at the corporate level. And in fact, this had some of the desired effect.

It increased dividend payments, which rose from 32% of corporate cash flow in 2002 to 41% of cash flow in 2004 and, over the longer term, from 35% of corporate cash flow in 1995 to 2002 to 40% of corporate cash flow in 2004 to 2013. However, as the flood of share repurchases in 2006 to 2007 and from 2012 on have made clear, it was a very incomplete reform.

Bush should’ve made dividends tax-deductible instead, thus making dividends equivalent to debt interest and equity equivalent to debt in the capital structure.

This change would’ve kept management from playing games and also would’ve eliminated corporate tax shelters, as corporate earnings could’ve then been distributed to shareholders to avoid corporate taxes.

Furthermore, tax-deductible dividends would’ve reduced the excessive pools of cash in corporate coffers, removed a huge tax management industry, and made capital allocation in the U.S. economy more efficient. Companies like Apple (AAPL), for example, wouldn’t have to keep $1-trillion worth of cash overseas to avoid taxes; instead, they could simply distribute it to their stockholders without tax being levied.

Obama Will Make Things Even Worse

Unfortunately, Obama – rather than learning from Bush’s errors – wants to continue making things worse.

His administration’s December 2012 tax deal partly undid the 2003 reform, raising the dividend tax rate to 20%. In addition, Obama implemented a 3.8% net investment income tax to pay for Obamacare, which raised the dividend tax rate to 23.8% for high-income individuals.

And now, Obama’s latest proposal would increase the tax on corporate dividends to 28% (or 31.8% including the net investment income tax).

Interestingly, this latest proposal is justified as an anti-rich measure – which can be traced back to Bush’s dividend tax structure, which allowed politicians to demagogue dividend payments as rich people’s earnings. Yet if dividend payments were treated like corporate debt interest and were fully taxable to individuals, there would be no “loophole” that could be closed by zapping the rich.

The bottom line is that Obama’s dividend tax would reduce the net income of income investors by 10.5% from the tax effect alone. In addition, it will further encourage companies to reduce dividends and increase leverage and share repurchases, since those structures are more tax efficient.

U.S. dividend tax is already an unfair mess, and now, Obama’s tax change threatens to make a bad situation even worse.

Good investing,

Martin Hutchinson

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Source: Wall Street Daily