Matt HealeyThursday,6 December 2012

The Snap:

There has been a lot of talk recently about the tax code. Most of this has focused on the tax rate for the upper two tax brackets. There has been a little discussion about the taxes on dividends and capital gains. Currently dividends are paid out of after tax profits, and taxes differently than ordinary income. I would like to see two changes. First, allow companies to pay dividends out of pre-tax profits. This way they would considered to be similar to interest payments. The second change would be to tax dividends as ordinary income.

The Download:

There are a lot of problems with the current system. Corporations use a lot of debt financing rather than equity financing because of the tax advantages. They hoard cash to avoid paying a double tax on the dividends, once when the money is made for the corporation and once more when it is paid to share holders. As I have written about before, this leads to an inefficient use of the cash. Allowing corporations to pay dividends out of pre-tax income will solve some of these problems.

Companies do not like to pay taxes. By knowing that, if you allow them to pay dividends out of pretax income, then they will pay out more dividends specifically to avoid the tax burden. The dividend will almost exactly match the GAAP profits, which will eliminate the corporate tax. This will transfer the money to the shareholders and thus greatly reduce the current cash hording that is going on. Additionally this approach will solve the problem associated with companies holding cash outside of the U.S. In many cases, U.S.-based companies conduct business outside of the U.S. Any profit that companies make stays outside of the U.S., because if it is repatriated, then these companies will have to pay taxes on the repatriation. Thus, cash is held outside of the U.S., in order to avoid the repatriation tax. If we allowed the payment of dividends out of pre-tax income, then this money could be repatriated, and a dividend declared. This would directly offset the tax.

But the problem is that we can not reduce the amount of revenue for the U.S. Treasury. So that is where the second reform comes in. Tax dividends as ordinary income. Now, when the increased amount of money is paid out, it will be taxed as income for the investors. And after all, isn’t that what it is, income?  The side benefit of this system would be it would make the tax system more progressive. With dividends taxed at lower rates, the tax system becomes less progressive, as the wealth pay lower taxes on a large potion of their income. Personally, I think that a progressive system is a benefit to society. Additionally, with more money being returned to the shareholders, it could then either be re-invested, or spent. Both of these things have positive economic effects.

Hat Tips:

US Dividend Tax Problems, Image Credit: Wikimedia Commons

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