Man Without Qualities

Thursday, January 16, 2003

Fearful Asymmetry

In the Wall Street Journal Burton G. Malkiel writes elegantly about the proposed elimination of federal income taxes on dividends:

The president's proposal would have important long-term benefits. It will eliminate the tax-induced incentives that make corporations adopt overly leveraged capital structures and contribute to a misallocation of corporate resources. It will boost stock prices, improve credit equity, and strengthen corporate governance. The proposal is worthwhile because it will both stimulate the economy and have important effects on long-run efficiency.

The present system has had two undesirable effects. First, it has encouraged a dangerous buildup of debt at the expense of equity financing. ... Second, the tax system has encouraged a dramatic change in corporate dividend behavior. To the extent that stocks are held outside of tax-advantaged retirement plans, dividends are taxed at regular income-tax rates while capital gains are taxed at much lower rates if realized. More important, the tax on unrealized capital gains is deferred and can be eliminated completely if stocks are bequeathed to one's heirs. ...

By eliminating the personal income tax on dividends, the tax system will become more even-handed in the treatment of debt and equity. While debt financing will retain the advantage of allowing interest to be deducted from corporate taxes, interest received will continue to be fully taxable when held outside of tax advantaged retirement plans. Dividend payments will come after the payment of corporate taxes but the recipients will not be taxed. Assuming an average marginal corporate and individual tax rate of, say, 35%, both debt and equity would be treated in roughly an equivalent fashion. ... My guess is that eliminating the double taxation of dividends would lead to a powerful rally in stock prices ...

That all seems to fit together fairly well. But aren't there a few asymmetries here that might matter? The most basic way of measuring the value of a stock is to discount its expected dividend yield. In that sense, the proceeds of the sale of a share of stock can be thought of as essentially dividends on the stock received by the seller in advance. If income taxes on dividends are to be eliminated, then why tax the proceeds of stock sales at all? Professor Malkiel correctly points out that under the current system capital gains are taxed at much lower rates [than ordinary income] if realized. More important, the tax on unrealized capital gains is deferred and can be eliminated completely if stocks are bequeathed to one's heirs. But why should shareholders have incentive to hold stock until they die? A main point of the capital markets is to place ownership (stock) in the hands of the best owner - but capital gains taxes obstruct that. The elimination of dividends taxes makes a stock worth more if one buys and holds - but stock prices are the price one receives if one sells. Won't continuing to tax the gains from stock sales have a rather strong dampening effect on that powerful rally in stock prices that Professor Malkiel is hoping for?

More generally, what is the justification for the tax system distinguishing between a tax free dividend and a taxable sale of a security that in many respects amounts to nothing more than a stream of expected tax free dividends? Many tax experts and economists express concern at the huge efforts expended under the current system in the pursuit of capital gains treatment for commercial transactions. But the gap between the proposed 0% tax rate on dividends and capital gains rates is larger than the gap between capital gains rates and Professor Malkiel's posited average marginal tax rate of 35%.

The remaining asymmetry between dividends and stock sales seems to leave many opportunities for tax mischief in place. For example, consider a corporation that sells all of its assets. The profits from a sale of appreciated corporate assets are taxable to the corporation. But what happens if the corporation instead borrows against its assets, pledging the assets to the lender, passes the loan proceeds up to shareholders as a tax-free dividend and then defaults on the loan? The lender will foreclose on the assets, pay off the loan and return very little to the corporation with which it can pay the tax bill arising from the foreclosure sale. The shareholders are not liable for the tax bill unless the entire transaction can be characterized as a "fraudulent conveyance" or the like - which is very hard to do. Of course, under the current tax code the shareholders and the corporation already have an incentive to engage in this kind of transaction - but the sale proceeds received by the corporation are subject to high "double taxation," so the incentive is less.

For example, suppose the asset is not a “capital asset" and the sale proceeds are $100. That means only $65 is left after the corporation pays its taxes - and the shareholders retain only $42 after they pay their taxes (assuming, with Professor Malkiel, an average marginal corporate and individual tax rate of 35%. With the phony loan alternative the shareholders retain $65 under current tax law - so under the current law the loan scam is worth $23 to the shareholders.

If corporation sells its assets after the proposed reform is enacted, it still retains $65 after paying corporate income tax to be passed as dividends. If it uses the phony loan scam, it has $100 to pass as dividends. Dividends are tax free, so the shareholders retain all $65 in the sale case but retain $100 if the phony loan structure is used. The loan scam is therefore worth $35 to the shareholders under the proposed tax reform - a substantial increase in the incentive to commit tax fraud from the $23 incentive under current law. Indeed, the incentive to commit tax fraud increases by about 50% in this simple example.

The main justification for the asymmetry between dividends and stock sales appears to follow from the corporate income tax. In the simplest case, again suppose a corporation owns nothing but one appreciated asset, which it sells. The profits from a sale of appreciated corporate assets are taxable to the corporation. Only the after-tax profit from the sale would be available for dividends. But if the shareholders could sell their stock tax free, they could receive all of the sale proceeds tax free. Retaining the capital gains tax on the stock sale makes the stock sale and the asset sale have similar tax consequences (makes them more symmetric!) - and that's good tax policy. But it's good tax policy only if one assumes that the corporate income tax is a given.

The corporate income tax is unwise in the first place - and it's strange to see it apparently driving this aspect of the proposed reform. There are many good arguments - many of them economic - against the corporate income tax. But all of those economic arguments have a single, simple answer: they can't work politically in an atmosphere charged with the rhetoric of class warfare. Elimination of the corporate income tax is presented in this atmosphere as a boon to the rich. So I would like to note one argument against the corporate income tax which is mostly political and not economic: the corporate income tax mostly hurts the very public corporations that people of more modest means invest in. Private companies with small numbers of owners can form themselves as "limited liability companies" or "partnerships" or "S-corps" - none of which pay taxes. The owners do pay taxes on the distributions (dividends) received from these entities - which is exactly the reverse of what happens in the corproate case under the proposed reforms. Another suspect asymmetry!

Why should a good class warrior want public corporations - which are the only companies in which most people of modest means may and do invest - to be disfavored by the tax code? If passage of the President's reforms becomes more certain, doesn't it make more sense for the Democrats to argue that simple elimination of the corporate income tax across the board while retaining taxation on dividends, is a more, well, democratic, alternative?

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