Taxes, Dividends, and Distortions (2002)

Had its stock descended from $90 to $1.60 and languished there, Enron Corporation would merely have joined dozens of other casualties of the new economy in Wall Street's purgatory. But the stock's final descent, from $1.6o to virtually zero, has instead earned the company a place in the Beltway's special hell. Now Enron's name is invoked to buttress every argument imaginable, from reforming campaign finance laws to not reforming the Social Security system. Ironically, the one reform that Enron's unfortunate history does clearly support still receives scant congressional attention: changing those provisions of the Internal Revenue Code that tax corporate dividends twice. Unlike dividends, interest payments are taxed only once, so the tax code has nurtured some extraordinarily complex derivative securities that turn equity into debt for the IRS and debt into equity for Wall Street. Enron pushed the use of these securities way too far, of course, but reformers who worry that the company's practices are merely the tip of a vast iceberg might at least consider the origins of the ice. Such consideration may provoke a much closer look at the tax treatment of dividends and how it has bred problems that extend well beyond these issues of corporate accounting. In essence, tax policy encourages corporations to hold on to shareholders' money forever. By taxing earnings at the corporate level and taxing them again upon distribution to the shareholder, state and federal government can claim 65 percent of the income. Since over half that tax is avoided if the corporation retains the earnings, shareholders have become more willing to let management perpetually reinvest their money -- and management has been even more willing to comply. This policy encourages corporations to find increasingly imaginative uses for their shareholders' money, including stock repurchase plans that often benefit shareholders much less than they benefit executives who hold stock options. Disappearing dividends The internal revenue code has long favored the reinvestment of corporate profits over their distribution. When income taxes first rose high enough to have major economic impacts, the country was fighting World War II and the fine points of corporate finance weren't part of the public agenda. After the war, when tax policy did become a high-profile issue, there was widespread concern that depression might return unless investment was vigorously encouraged. With dividends taxed at rates over 90 percent throughout the 1950s, there was a strong incentive to plow every cent back into the business. Even so, the average dividend yield on public companies remained fairly high. Economists were puzzled over the persistence of high dividend yields in the face of such tax inefficiency, and many predicted that dividends would eventually disappear altogether. But until about 10 years ago dividend rates on the stock of large, well-established firms held up fairly well both as a percentage of profit (the payout rate) and as a percentage of the value of the stock (the yield). In one sense, however, dividends have been falling steadily since the 1950s. The year 1958 was the last time the dividend yield on the S&P 500 was actually higher than the yield on high-quality corporate bonds, reflecting the popular view at the time that investors needed higher equity yields to compensate for the additional risk. Since then, the decline has been steady -- and dramatic. (Note also the absolute drop in the dividend yield from 1990 to 2000 -- a decline that occurred at the fairly constant rate of 25 basis points per year throughout the decade): Dividend Yield Average Yield on Ratio of Dividend on S&P 500 AA Corporate Bonds Yield to Bond Yield 2000 1.10% 7.60% 14.53% 1990 3.68% 9. …