In attacking the credibility of many public companies’ financial statements, and calling for yet more stringent regulations, the U.S. government claims to champion the small investor; but in reality its own dividend taxation policy is largely to blame for the problem it now seeks to fix.
Historically, for the small investor who lacked the time and resources to interview management, scour financial statements and perform other independent due diligence, the simplest, and surest method to confirm that a company was actually earning the income it claimed was to examine its dividend payment record.
Dividends, i.e. a distribution of a corporation’s earnings to its shareholders, are the most straightforward way in which a company can provide a return to its risk-taking owners. A company which consistently pays dividends, and whose dividend growth tracks its reported earnings growth, is one which consistently makes money, and more importantly, one which has nothing to hide. Companies having questionable dealings, e.g. use of off balance sheet liabilities or other accounting gimmicks to inflate earnings, typically don’t have any cash to pay out, even though they may claim stellar earnings. Thus to the small investor, the single best objective measure to verify the long-term success of a company is its dividend history.
Yet our current tax code greatly penalizes public companies from paying dividends by double taxing them.
When a corporation earns income, it pays taxes on the income at the corporate level. If it then seeks to return some of these after-tax earnings to its owners, our government levies a second round of taxes at the individual’s level. As a simple example, consider a hypothetical corporation.
Let’s say that the corporation is a successful one, and after all expenses earns $1,000 in a given tax year. The typical effective corporate tax rate is around 35%, so our government immediately confiscates $350 of the earnings at the corporate level, leaving the corporation with $650.
When the corporation then distributes the remaining after-tax earnings to its risk-taking shareholders, it does so in the form a dividend. The shareholders receiving the dividend are then taxed again, and assuming a marginal personal rate of 40% (state and federal), the government confiscates another $260.
So, of the $1000 produced by individuals risking their capital and successfully anticipating the market’s demands, the government takes $610, and leaves $390 to the individuals.
Little wonder that companies in today’s tax climate choose not to pay dividends; and thereby deprive the small investor of his best appraisal tool.
The U.S.’s double taxation of dividends is even more disconcerting when one considers that many countries with which we compete recognize double taxation to be a great disservice to individual investors and to the economy in general. Countries as diverse as France, Mexico, Finland, and Australia have completely eliminated double taxation of dividends and many others have almost entirely eliminated it.
If the US government is serious about improving our investment markets, instead of imposing yet more onerous regulations on our corporations, it should discontinue double taxation of dividends by immediately repealing all taxes of dividends at the individual’s level. This would open the door to companies once again paying dividends and thereby provide potential investors with a true objective measure of a company’s performance and credibility.
