The folly of eliminating taxes on dividends.

This week's harebrained proposal to rocket stocks back up to their late-'90s peaks: Cut or eliminate the taxes on corporate dividends.

Wall Street economist Henry Kaufman urged abolishing the tax in Wednesday's Wall Street Journal. Writing in the New York Observer on the same day, Nicholas von Hoffman said investors' moods would improve if stocks paid 5 percent dividends and that all that's needed to convince companies to start paying them is a "slight change in ... income-tax law—eliminating the tax on dividends to people with gross incomes of, say, $300,000 or less." And if Congress stopped its "double taxation" of dividends, James Glassman, the co-author of Dow 36,000, argued in the American Enterprise, "shareholder dividends would recover, and small investors would regain a powerful tool for separating real successes in business from the impostors."

As someone who would like to see stocks go up rather than down and see taxes fall rather than rise, I'm sympathetic to the argument. But this proposal smacks more of bear-market desperation than intellectual good sense.

Dividends, like the Renault Fuego and a Flock of Seagulls, went out of fashion in the '90s. Instead of cutting checks to shareholders each quarter, companies retained earnings and invested them to expand capacity and improve productivity. The companies that notched the most impressive performances of the decade—Dell, Microsoft, et al.—didn't pay dividends. Investors plainly prefer their returns in the form of capital gains. After all, since the 1997 capital gains tax cut, such gains are frequently taxed at a lower rate than dividends. Today, the S&P 500 has an indicated dividend yield of just 1.7 percent—down from 6.3 percent in 1982.

The chief argument of those who advocate eliminating taxes on dividends is that they are subject to "double taxation." Shareholders pay taxes on dividends at the rate their ordinary income is taxed. And corporations cannot deduct dividends from their taxable income, meaning they pay taxes on them, too. Does that mean that dividends are double taxed? Only if you subscribe to the belief that corporations don't pay taxes, people do. Under this theory, since a company's profits are ultimately distributed to owners and shareholders in some form—dividends, profit sharing, salaries, or capital gains—any tax on corporate income, or any limits on the deductibility of items from taxable income, in effect taxes the same dollar of profits twice. This only makes sense if, like Treasury Secretary Paul O'Neill, you don't draw a distinction between a corporation and the people who own it. "The corporations and businesses are just an intermediary between the citizens and the government," he said in an interview last year. (The logic of this dogma naturally leads its faithful to advocate abolishing the corporate income tax, as O'Neill does.)

But the double-taxation argument reflects a flawed understanding of what corporations do and why they are formed. Corporations are distinct entities. They are not merely passive conduits of cash. They are legal beings, chartered by states to perform certain objectives. They possess all sorts of prerogatives, rights, and protections not afforded to individuals. That's why people form corporations, and that's why it is just for corporations to pay taxes on their income. Too frequently, CEOs like O'Neill have failed to differentiate between themselves as individual citizens and the companies they run. (That may explain why Tyco's Dennis Kozlowski and Enron's Kenneth Lay thought there was nothing untoward about using their corporate treasuries as ATM machines.)

Besides, if we want to put dividends and capital gains on the same footing, the answer isn't to stop taxing dividends, it is to normalize the tax rates on capital gains so they are taxed just like other forms of income. Why create more invidious distinctions between different types of income?

Apart from philosophical reasons, there are plenty of substantive reasons to oppose eliminating the tax on dividends. Eliminating taxes on dividends would establish yet another source of tax-free income for the undeserving rich. The largest shareholders of many dividend-paying companies—New York Times and Ford, for example—are trusts whose beneficiaries are the descendants of company founders, for whom dividends are a chief source of income. Anybody who caught a glimpse of the Hilton family in Barbara Kopple's Hamptons documentary can surely understand why providing such people with more disposable income is undesirable.

Government tinkering with dividend taxation is sure to have unintended consequences. In this instance, it would create an incentive for companies to put more shares—instead of options—into the hands of bosses, so they could collect tax-free dividends. It might encourage corporations to pay out large dividends at the expense of their long-term health. Do we really want to provide executives with another tax-based incentive to enrich CEOs and other large, influential shareholders at the expense of a company's entire roster of stakeholders?

Unlike interest payments on bonds, dividend payments are voluntary. But companies that commit to pay dividends are effectively putting themselves on the hook for a liability.Firms that slash or eliminate their dividends frequently suffer retribution in the markets. Assuming a new liability may not be a wise move in a timethat calls for companies to manage their cash positions conservatively.