Man Without Qualities

Thursday, January 23, 2003

Misunderstanding Tax Incentives

Jeff Madrick writes in the New York Times that:

[T]he long-term benefits of the new tax package — in particular, the dividend tax cuts — are ... poorly thought out. Corporate income is taxed when it is earned. If it is paid in dividends, it is taxed again as income for investors. A cut in dividend taxes should spur corporate investment and long-term growth. But many who believe that such double taxation of dividends results in an inefficient use of capital and encourages too much debt, including this writer, do not believe that the current proposals are an optimal way to encourage growth.

One of the most intriguing questions is raised by an influential group of economists who cut across the political spectrum. This "new view," best represented in the United States by Alan J. Auerbach of the University of California at Berkeley, maintains that when companies invest out of retained earnings, they are in effect deferring the tax that would have been paid by investors had they paid out the money in dividends. It is as if investors simply had the money in a tax-sheltered 401(k) plan. So a reduction in dividend taxes has no stimulative effect on business investment for these companies.

How good is the theory? George R. Zodrow, an economist at Rice University, has long followed the empirical research and says that one of the most recent studies in the field, by Mr. Hassett and Mr. Auerbach, suggests that the elimination of dividend taxation would encourage only about half the nation's corporations to invest more.

If investors want to put their money in a 401(k), then not taxing dividends will allow them to choose a competent 401(k) money manager. There is nothing to be gained by allowing the officers of a company which is not an investment company to manage one's money beyond the business plan that served as the basis for one's investment. But Mr. Madrick - and also Professor Auerbach, if his thinking is adequately represented here - are much more off track in understanding the connection between "double taxation" and efficient growth than is indicated even by their confusion between the relative merits of an investment company and an operating company.

Contrary to Mr. Madrick's suggestion, "overleveraging" is not the only big problem aggrevated by "double taxation." This is not a secret. Milton Friedman, for example, put it this way: Eliminating double taxation of corporate earnings will end the present bias toward debt rather than equity in the financial structure of corporations as well as the present bias toward retaining earnings rather than distributing them as dividends. The combined result will be a more effective distribution of capital, and will promote a more effective market for corporate control. One of the most dubious and inefficient consequences of "double taxation" is that it encourages companies to retain earnings which could be better invested by other companies, if only they could get it.

Indeed, a later stage of the corporate life cycle is often a company's becoming a "cash cow" - a company with high cash revenues and only bad investment options. In the most extreme case, consider a company that sells most of its assets, retains the cash and has no good business plan. Mr. Madrick seems to think it would be a good thing that such a company nevertheless "invest" that money on the basis of tax considerations - rather than pass it up to its investors as dividends so that they could invest it in other companies that do have good business plans. But an efficient system would make corporations indifferent as to tax consequences in their decision to retain earnings or pass them as dividends.

That all means that an efficient market would normally have a large body of companies earning money which is passed up to investors and then given by them to other companies to invest. The problem is aggravated further by the current relative dormancy of the "market for corporate control" - a dormancy which further impedes the efficient flow of resources into the hands of those who could make better use of them - not just some use of them.

Encourage only about half the nation's corporations to invest more? That may be about right. Nothing Mr. Madrick presents in this article tells us that it isn't about right.

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