My view is that, in principle, replacing corporate income taxes with higher taxes on dividends and rich executives would be desirable. But in the interests of a fully informed public, I think it’s worth highlighting an underrated 2003 paper from Raj Chetty and Emannuel Saez that brings some important empirical perspective to bear on the issue. In theory, taxing $100 in profits and then taxing the post-tax profits again when they’re given to shareholders as dividends should be about the same as not taxing the profits and then levying a heavier tax on the dividends. But in practice, corporate executives are imperfect stewards of shareholder interests so how you structure taxes should make a difference to real-world behavior. And in “Dividend Taxes and Corporate Behavior: Evidence From the 2003 Dividend Tax Cut” (PDF), Chetty & Saez find that it does:
This paper analyzes the effects of dividend taxation on corporate behavior using the large tax cut on individual dividend income enacted in 2003. Using data spanning 1980 to 2004-Q2, we document a sharp and widespread surge in dividend payments following the tax cut, along several dimensions. First, an unprecedented number of firms initiated regular dividend payments after the reform. As a result, the number of publicly traded firms paying dividends, after having declined continuously for more than two decades, began to increase precisely in 2003. Second, many firms that were already paying dividends prior to the reform raised regular dividend payments significantly. Third, special dividends also rose. All of these effects are robust to introducing controls for profits and other firm characteristics. Additional evidence for specific groups of firms suggests that the tax cut induced increases in total payout rather than substitution between dividends and repurchases. The tax response was confined to firms with lower levels of forecasted growth, consistent with an improvement in capital allocation efficiency. The response to the tax cut was strongest in firms with strong principals whose tax incentives changed (presence of large taxable institutional owners or independent directors with large share holdings), and in firms where agents had stronger incentives to respond (large executive ownership and low levels of executive stock-options outstanding).These findings show that principal-agent issues play a central role in corporate responses to taxation.Translating into English, a dividend tax cut should induce firms to pay more dividends. And they find that it did induce them to pay more dividends. But it did so unevenly. Firms with strong shareholders and firms where managers’ financial incentives were strongly aligned with those of shareholders increased dividends more than firms with more severe principle-agent problems. In a follow-up paper, “Dividend and Corporate Taxation in an Agency Model of the Firm” (PDF), they bring a little more theoretical firepower to the table and argue that once you adopt a plausible agency model of the firm, you can see that taxing profits rather than dividends promotes efficient allocation of capital. One way to think about it is to imagine that you’re CEO of Microsoft and you also own a lot of Microsoft shares. Windows and Office are generating tons of profits and everyone agrees you should keep investing in those products, but everyone also agrees that the long-term growth potential there seems modest. So you have to choose between taking the extra profits and paying them out as dividends, or taking the extra profits and investing them in an unlikely-to-succeed effort to compete with Google’s core search business. Dividends appeal to you as a CEO because you’re also a shareholder and you like money. But Bing appeals to you as a CEO because you’re also an egomaniacal leader and you like the idea of defeating your corporate adversaries. Taxing dividends drives a wedge between the CEO and non-CEO shareholders, because it reduces the financial value to the CEO of dividends but the feeling of joy you get when you imagine the sad look on Larry Page’s face when Bing drives Google into bankruptcy can’t be taxed. Long story short, corporate income tax and dividend taxes both create a general disincentive for capital-formation. But when choosing between the two, relying on corporate income taxes encourages economically efficient reallocation of corporate capital whereas dividend taxes encourage managers to deploy capital in pet projects that have suboptimal expected financial value. My view is that dividends are boring and corporate governance is overrated, and that therefore this agency perspective is a reason to prefer taxing dividends to taxing corporate profits. I seriously doubt that Bing is a good business decision, but it’s great for America. The fact that competing with Google’s core search business is a bad business decision threatens to grant Google monopoly power over the search market and lead to all kinds of malfeasance. It’s really important for some deep-pocketed and technically competent firm to be out there willing to spend money on a possible futile effort to bring them down. Even if it never results in a better-than-Google product, it places a key check on Google itself in terms of what it will try to do with its search business. It is certainly true that a country can go too far toward poor corporate governance and inefficient capital allocation (this seems to be part of the Japan story), but a healthy level of managerial autonomy and centrally planned investment is an appealing alternative to excessive reliance on excessively complicated financial markets.
