Prior to the JGTRRA of 2003, dividends paid to individual corporate shareholders were taxed like other items of ordinary income (e.g., interest or rents) for federal income tax purposes. Dividends are paid out of corporate “earnings and profits”, a tax term of art that is designed to implement the difference between a return of one’s investment and a return on that investment. (Those who want to explore that further have to take my course in Taxation of Business Enterprises next semester. As you will see, it doesn’t always accomplish this designed purpose). What this means is that, in most cases, the dividends represent after-tax income at the corporate level. So, it has been taxed at least once, albeit to a different taxpayer (i.e., to the corporation, which is separate from the shareholder).
At various times in our history, capital gain income has enjoyed a preferential tax rate as compared to other kinds of income. In part, this takes into account the fact that a capital gain represents the expectation of future taxable income from holding the asset. If you buy an asset for $100 and someone else wants to pay you $200, there are lots of explanations for this. One could be the buyer is a bigger fool than you are. It could also be the case that the buyer sees value there from expected growth in the income producing potential of that asset. That means the seller is being taxed, in effect, on the future income stream. The buyer could be wrong, in which case she will experience a loss. But that is not your problem.
Many theorists think that an appropriate tax rate on capital gains would be zero. However, it has been hard to justify that to the political powers that be, as it gives rise to class warfare ideas. People with capital gains are “rich” and they need to pay their “fair share” – I think that is the mantra that would be repeated. So, a compromise position is to cut tax rates and have capital gain holders pay something, rather than nothing.
If you put these two components together, you can see how a rational corporate director concerned about the wellbeing of its shareholders would probably choose to do things to increase the value of shares, so that owners could reap tax-favored benefits from price appreciation, rather than cash dividends. Buying other businesses (the root of modern corporate conglomerates) or buying back shares are both methods to try to boost share values. Payment of dividends was not as good. Also, since interest and dividends get similar treatment at the investor level, why not finance with debt to reduce corporate tax payments?
The JGTTRA of 2003 changed all this by putting dividends and capital gains on a similar tax footing. Corporations have thus made some changes in this area, paying higher dividends. A story posted December 3 in the online Wall Street Journal outlines the phenomenon of returning dividends to shareholders, which has indeed been happening.
Cash dividends are good indicators of corporate profitability. You can fool shareholders with phantom accruals of earnings (ala Enron), but cold hard cash payments are tangible evidence of something positive. You could still fool shareholders for a while (for example, Ford will continue paying dividends despite mounting losses) but the rational investors will realize this is not going on forever.
Cash dividends also present practical problems, especially for smaller investors. DRIPs (reinvestment programs) allow more stock to be bought. The $27.50 you get each quarter from 100 shares of Conagra would mean you have to follow all these purchases over time. It is a hassle to keep those books. If you are not in a DRIP, you have some cash to spend or reinvest, but that means a decision must be made. For folks who need income, though, this is a nice problem to have. You get a choice – rather than having the choice made for you by a corporate board and forcing you to sell off some shares to get some spendable cash (which, of course, will involve transaction costs).
For a mutual fund, dividends generate liquidity, which can be used for more investments or to redeem shares. It’s good for mutual fund shareholders to have some freedom in corporate dividend policies. (Folks who think that only the rich benefit from dividend preferences should take this into account – their focus on who owns stock on an individual basis misses this important point.)
Unfortunately, like so many other tax cuts enacted during the first half of this decade, it was not a permanent change. The tax preference here would expire after 2008, injecting uncertainty into the mix. A current provision in the House would extend this to 2010 (See HR 4297). However, no permanent change is on the horizon. This sensible policy needs to be extended.