Why We Should Untax Dividends
by Fred E. Foldvary, Senior Editor
Dividend incomes should be free of income taxes to the extent they have already been taxed at the corporate level. It is doubly unjust to tax the same profit twice.
A corporation is a legal person, unlike a partnership. As a legal person, a corporation has title in its own name to its property and its income. Of course the shareholders are the actual owners, but for accounting and legal purposes, the corporation is treated like a person and is subject to income taxes on its profits. Since the shareholders are legally separate persons from the corporation, when the remaining corporate profits are distributed to the stock owners as dividends, the profit is taxed again by the personal income tax. Thus the double taxation of dividend income. Double taxation can result in most of the profit being taxed away.
In contrast, the profits of a single proprietor or a partnership are only taxed once. Interest income, such as from bonds, is only taxed once. Taxing a profit twice is unjust, because justice requires an equal treatment of income, given that it be taxed. Taxing profits twice also results in economic distortions. The chiefs of a corporation have the choice of retaining the earnings or transferring them to the shareholders as dividends. Since much of the dividend income is taxed, many corporations have chosen to pay little or no dividends. This puts the funds at risk, since a large hoard of cash can be a temptation to splurge on nonessential spending. Secondly, the chiefs have a choice of obtaining funds either from borrowing or from issuing more stock. Taxing dividends skews the choice more towards borrowing. So corporations end up with too much debt, which can be fatal if profits decline and the firm is unable to pay the interest.
In a market so pure that it shines like a crystal, dividend income serves to stabilize the price of shares of stock. The price of a stock becomes the expected profit divided by the real interest rate. Taxing the profit and the dividends mucks up the crystal, inflicting impurities that cloud it. The firm borrows instead of issuing more stock, increasing risk, and the firm retains earnings, creating uncertainty as to whether the shareholder will ever get that profit. Taxes distort the earnings of both the corporation and shareholder; the already clouded crystal gets twisted out of shape, and the price of the share becomes less anchored to the reality of profit. Comes an economic storm, and the crystal shatters.
Critics cry that reducing taxes on dividends benefits the rich. But whose money is it in the first place? The critics of the dividend tax cut think like accountants instead of like economists, and as to the morality of it, they reflex rather than think. The economic way of seeing peers through the superficial surface of economic activity. The bedrock economic reality is that of the factors of production, the categories of resource inputs, namely land, labor, and capital goods. Their returns are rent, wages, and rentals of capital goods. Profit as well as interest can be a return to any of these factors.
The bedrock morality is that a human being is properly a self-owner who thereby also properly owns his labor and wages. Stealing and taxing away wages is therefore immoral. Land is a gift from nature, and bedrock morality endows human beings with equal rights which implies an equal benefit from nature's land and the land values that arise from government-provided civic goods. Public finances should come from rent, with wages untaxed, no matter how high they are. Those who seek to tax wages just because they are higher are no better than highwaymen who loot just because the money is there.
Capital goods are produced from land, labor, and earlier capital goods, and so once the rent is tapped for public revenue, there is no need to tax rental return of capital goods. When investors get together to form a joint stock company or corporation, the profits of the firm will come from the factors land, labor, and capital goods. In a proper system, the land rent has already been tapped as a civic rental to pay for civic goods either by government or a community association or a proprietary entrepreneurial community. The profit will thus be net of the land rent, and so should be utterly, totally, completely, and absolutely tax free.
The economic way of thinking does not regard land rent as part of the economic profit of a firm. Land rent is an implicit if not explicit cost incurred by a firm that must be subtracted from revenue to get the real or economic profit. But today, the corporation's assets includes its own land from which the rent is kept as part of the accounting profit. Much of the income that accountants categorize as interest and dividends, as well as retained "earnings," is really land rent. When that income gets taxed, in effect the government is taxing the land rent, along with income from wages and capital goods. But the form of taxation counts more than the amount. Lumping all the factors into an accounting category such as profits or dividends taxes all the factors, and creates disincentives for the active factors, entrepreneurship and capital goods.
Untaxing labor and capital goods is a reform that is not now on the legislative table. On the table is the untaxing of dividends. Even though reducing the tax on dividends would eliminate a bit of rent from taxation, the beneficial effect of avoiding the double taxation of returns from labor and capital goods swamps it. Ideally, dividends should be untaxed the way some countries do it, by providing a tax credit for the portion of dividends that was taxed at the corporate level. But even if the reform is a reduction of personal income taxes, eliminating the double taxation of dividends will benefit the economy in the long run.
Dividends are not just for the rich. Many retired people depend on income from dividends. Eliminating the double taxation of dividends is the right thing to do for the retired as well as for the economy and to avoid unfairly penalizing investments in dividend-paying shares.
-- Fred Foldvary
Copyright 2003 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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