Saturday, April 10, 2010

Taxation of Dividends

Making dividends exempt from income taxation is anathema to liberals and perhaps a majority of the US population, because its direct beneficiaries are the wealthier half of the population and the amount of the benefit would be directly proportional to how rich you are. A sizeable minority of the population, those owning no stocks, would not benefit at all. One could argue, however, that a number of social problems would be alleviated by having corporations increase their dividends. If we can identify steps that would lead to larger dividends, such as through the tax code, they should be considered. For example, I suggest that in exchange for a slightly higher corporate income tax rate, any dividend paid out of retained earnings be tax free to the investor. The benefits of greater dividends include the following.

1. There would be less reliance on net income accounting in determining profitability of a corporation. Dividends now are a small fraction of earnings, and earnings are the prime focus of investors in evaluating stocks. With the focus on earnings, there is a strong temptation to inflate non-cash income in reported earnings, undermining investor confidence and creating volatility in asset prices. An increased focus on dividends would also reduce fraud along with more benign forms of bias in reported earnings.
2. Resources would be invested more efficiently because there would no longer be a tax rationale for hoarding cash.
3. Retirees would draw more income from the dividends on their stocks and there would be less pressure on Americans to save massively for retirement. If dividends are 2% to 3% as they are now, Americans need to save about $2 million to receive $50,000 per year in dividend income. They could obtain additional funds by selling appreciated shares, but buying and selling shares is a fundamentally speculative activity, not an appropriate foundation for retirement planning for a broad segment of society. Doubling the dividend rate cuts the target in half.