Save the Dividend Tax

President Bush’s new economic plan, scheduled to be unveiled this week, will include a tax break for people who receive dividends from stocks. The president is right to focus on the dividend tax—but he should give the tax break to the corporations that pay the dividends, especially if he wants to encourage a change in corporate behavior.

The problem is that today’s tax code gets in the way of prudent corporate financial management. Corporations pay interest on their debts out of their profits before taxes, while dividends must be paid from profits after taxes. Thus the tax code gives companies an incentive to finance their activities by borrowing money rather than by selling stock, which would spread the risks and rewards of the enterprise among the community of stockholders. Some of the worst excesses of the recent boom were in effect sponsored by this element in the tax code. Because corporations tend to borrow instead of issuing stock (and sometimes use the cash from borrowing to buy back their own stock), our economy is more highly leveraged, and more fragile, than it would otherwise be. Even very profitable companies that don’t have to borrow to buy back their stock are encouraged by the current tax code to use their profits to buy other companies.

When a company buys its own stock on the market, it reduces the supply available to investors, thereby increasing the likelihood that its share price will rise. The process of increasing debt and decreasing equity appears to raise earnings per share (fewer shares, after all), apparently justifying the higher stock prices. Thus corporate managers who consider their great mission to be “enhancing shareholder value” can perform that mission—albeit briefly—without improving the real performance of the company. Meanwhile, the corporation accumulates stock for rewarding executives with lucrative options packages.

Cutting the individual income tax on dividends would do little to discourage such corporate mischief. Moreover, it would be unfair and appallingly complicated for the institutions that serve as investment vehicles for ordinary Americans.

Most Americans who invest in the stock market don’t currently pay taxes on dividend income. Their savings are in retirement plans like 401(k)’s, and dividends paid to these funds are not taxed. A law that made dividends tax-free would do nothing to put money in the pockets of people with all their stock in retirement plans.

Under the proposals reported to be in preparation, people who have saved money in certificates of deposit, savings accounts and government bonds would still get Form 1099’s at the beginning of the year, notifying them that the I.R.S. had been told about their interest income and that they are expected to pay taxes on it. One does not envy the Republican Congressional candidate who has to explain to middle-class voters that under the Bush tax plan they will still have to pay taxes on the interest earned in their savings accounts—but voters who own stock will no longer need to pay taxes on dividends.

Of course, exempting dividend payments from corporate income would probably reduce federal revenues—but the loss may not be as great as many fear. Corporations may react to the change in the tax code by paying more dividends, and some significant fraction of those payments would go to accounts that are not tax-deferred, resulting in greater personal taxable income.

The impulse to revise the dividend tax is a good one. Today’s tax code distorts corporate accounting and warps corporate behavior. The president’s plan, however, would do little to remedy the damage wrought by an ill-conceived tax code—and would make it even more unfair.