Dividend Plan Will Increase the Value of Firms

Dr. Stanley Jay Feldman
President Bush’s tax plan calls for the removal of double taxation of dividends. While this has been heralded as another example of giving the rich even bigger tax breaks, such rhetoric is fallacious. Removal of the dividend tax will result in lower long-term interest rates, increase economic growth, create jobs and be a major boon to small business owners. Removal of the dividend tax will have the following benefits:

1. Equity values of public and private companies will increase further once investors are confident that the dividend tax will be permanently removed.

Stock prices have increased because removal of the dividend tax means stockholders receive more after-tax cash flow. But private firms’ equity values will increase as well. Private firms do not have to disclose their financial condition to the public. Since these firms are run for the benefit of their owners, they have great latitude as to how they categorize income. Under the current system, owners try to move as much income as possible to the expense line so the business shows little or no taxable profit and pays virtually no business tax. Since the owner is the recipient of this income, it is only subject to one level of taxation at the personal level. For example, it is not unusual for an owner of a private firm to pay himself an exorbitant salary. This salary is treated as an expense for tax purposes but is really made up two components, a market wage the owner would have to pay an unrelated party to do the owner’s job plus a dividend. By treating the dividend as an expense, the owner only pays tax on the dividend at the personal level.

Under the proposed legislation, there is less incentive to “legitimately” characterize income as expenses. Thus owners of private firms should be much more willing to present their financial statements in a way that better reflects the true financial condition of the firm. Since the elimination of the dividend tax will make the financial condition of private firms more transparent and therefore less risky, the value placed on them will be much greater than under a dividend tax regime, all else equal. Assuming that the estate tax remains, higher valuations of private firms will create greater estate tax revenue than would be the case under the current tax regime. While this will not help solve the current state fiscal crisis, it will become an important source of incremental revenue moving forward.

2. The credit risk of corporations will significantly improve.

Businesses use debt and equity to finance investing activities. Under current law, interest on debt is a tax-deductible expense, while dividends are paid from after- tax business income. Thus the government tax policy subsidizes corporate interest expense, which makes corporate debt cheaper than it would be if the tax system treated debt and equity on an equal footing. Therefore removal of the subsidy should result in firms reducing their reliance on debt, thus making firms less risky and therefore less likely to default. The supply of corporate debt will also be reduced, leading to lower long-term interest rates, which will stimulate investment and economic growth.

3. A reduction in misguided acquisitions will occur reducing the financial and human costs of strategic failure.

CEOs of firms have traditionally been reluctant to pay large cash distributions to owners for a variety of reasons. One key reason is that any distribution would be subject to the dividend tax. Rather than pay a cash dividend, CEOs have used these funds to make acquisitions. The record of strategic acquisitions has been horrible, to say the least, and stockholder wealth has been significantly reduced as a result. But these acquisitions have also taken a large human toll, as acquirers terminate employees in the pursuit of a misguided strategic vision. By removing the dividend tax penalty, CEOs will be less likely to make irrational business decisions and justify them, in part, as a way to reduce the stockholder’s tax burden. Moreover, CEOs will now be able to allocate firm resources in more productive ways thereby increasing the possibility of extended profit growth and expanding job opportunities. Owners of private firms also store large amounts of cash on the balance sheet. Like their public firm counterparts, removal of the dividend tax would free up resource for more productive uses.

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