Fault the Tax Code for Low Dividend Payouts

Reducing the marginal tax rate on dividend income was not the optimal modification of the tax code. The U.S. corporate tax code continues to favor debt over equity because corporate interest payments are tax deductible whereas dividend payments are not. The recommendation in this article is that dividend payments be deductible at the corporate level and fully taxable to investors at their marginal income tax rates. The benefits should be a decline in debt financing and bankruptcy risk, substantial increases in dividend payouts, fewer stock option grants to managers, a decline in the equity risk premium, and higher stock valuations. Reducing the marginal U.S. tax rate on dividend income was a move in the right direction but not the optimal modification to the tax code. The intent of the legislation was to reduce the double taxation of dividends, which was accomplished. But the real problem is that the U.S. corporate tax code continues to favor debt issuance over equity issuance because corporate interest payments are tax deductible whereas dividend payments are not. We recommend that dividend payments, as well as interest payments, be deductible at the corporate level and be fully taxable to investors at their marginal income tax rates.Our proposed change in tax law would have numerous benefits: Debt financing should decline because debt's tax incentive will have been eliminated. Less debt would lead to lower bankruptcy risk.Dividend payout ratios should increase substantially. Failure to pay out dividends would give rise to corporate income taxes that otherwise could be avoided.Shareholders would receive more of their returns as dividends and less as capital appreciation. If capital appreciation is modest, then the value of incentive option grants diminishes, which should bring about a decline in the abuses associated with these options.If dividends increased substantially, corporate managers would be forced into the capital markets to raise equity capital to finance expansion. If investment bankers acted as underwriters, they would have to ensure that all is well at the issuing companies because the bankers would have their own capital at risk.Even with equal tax rates on capital gains and dividends, as now exist, companies may not increase dividends because investors can defer capital gains taxes whereas taxes on dividends have to be paid when the dividends are received. Our recommended modification to the tax code would force companies to increase dividends to increase stock value. Increased dividends would mean that managers would have less cash available for inefficient empire building.Investor confidence in companies that paid out the great majority of their earnings could increase because higher dividend payout ratios would assuage concerns about inflated earnings. Consequently, under our proposal, the required risk premium would decline for high-dividend-paying companies, which should increase stock valuations.Of course, our proposed change could have some drawbacks: Investors' ability to defer taxes would decline unless investors transferred their investments from mutual funds into high-cost variable annuities.Federal tax revenues would decline because employee benefit plans defer taxes and investors might do the same by shifting their investments into variable annuities. The tax revenue decline would be temporary, however, because the taxes would be payable when the investors withdrew funds for consumption.Because dividend payouts would have to increase, companies would need to enter the capital markets to fund their new projects or investments. Issuing equity can be costly, but if the number of equity deals available to bankers increases, the efficiencies of scale should reduce underwriting costs.If the costs of issuing equity are prohibitive, companies could "sweeten" dividend reinvestment plans by issuing new stocks to existing investors at modest discounts. The cost of the discount would be less than the tax savings generated by higher dividends.High-risk companies might want to retain earnings and pay taxes rather than issue new equity because of the high issue costs they would face. This scenario should happen only if the issue costs for these companies exceed the tax penalty because their tax rates are low.In conclusion, the benefits of our tax code change would be declines in debt financing and bankruptcy risk, substantial increases in dividends, fewer stock option grants, and a decline in the equity risk premium. We expect that such a policy shift would also increase stock valuations.