FROM THE OFFICE OF PUBLIC AFFAIRS

The President has proposed a bold plan to end the double tax on corporate profits.

THE PROBLEM.

When a corporation earns a profit it pays tax at rates as high as 35 percent.  For example, a corporation with $100 of taxable income could pay as much as $35 in corporate income tax.  Then, if the corporation pays dividends to its shareholders out of its remaining after-tax income of $65, the shareholders would pay tax on the dividends at their own individual tax rates, which range as high as 38.6 percent. The resulting rate of tax on corporate income can be as high as 60 percent, far in excess of tax rates imposed on other types of income.

The double tax affects companies’ business and investment decisions in ways that can be harmful.  They borrow money instead of issuing stock, because interest is deductible and doesn’t bear the double tax, while dividends are not deductible. Higher debt burdens leave firms vulnerable during downturns.  The double tax discourages companies from paying dividends – indeed, many companies have reduced their dividends – or stopped paying dividends altogether – to reduce the double tax.

The President believes the tax code shouldn’t interfere with business decisions.  That is why he has proposed getting rid of the double tax.  Once it is gone, businesses can decide whether they should pay dividends without worrying about taxes.

HOW WILL IT WORK?

Corporations will compute and pay tax just as they always have.  Then, they will do a simple calculation to compute how much of their income has been fully taxed.  This step will determine how much the corporation can pay out in tax-free dividends.  This step is important because the President has only proposed eliminating the double tax.  The fully-taxed amount, less the tax paid by the corporation, is the amount that can be paid tax free to shareholders.  So, in the example of a $100 profit and $35 tax, the $65 of after-tax profits could be paid to shareholders in cash without tax.

What happens if the corporation isn’t fully taxed?  Under the President’s proposal, this will mean that less cash can be paid tax-free to shareholders.  The reason – not all the profits have been fully taxed to the corporation. Consequently, corporations will have a reduced incentive to engage in transactions just to minimize their taxes. 

What if the corporation doesn’t want to distribute all its profits as dividends?  Businesses have legitimate reasons for retaining earnings, such as the need to reinvest in plant and equipment.  The President’s proposal would allow the corporation to do so.

Consider a similar example as before but assume these amounts apply on a per share basis ($10 of profits per share, $3.50 in taxes per share, and $6.50 in after-tax income per share).  Suppose the corporation paid out $4 in tax-free cash dividends per share and reinvested the remaining $2.50 per share.  The proposal would allow shareholders to add the amount the corporation retained to the amount they paid for their stock.  This treats shareholders the same as if they received a cash dividend and reinvested the dividend in new shares of the company.  The $2.50 of retained earnings would be tax-free, just as if it had been paid as a cash dividend.  For example, if a shareholder had bought a share of stock for $90 and sold it for $100, his or her gain would be $7.50 instead of $10 [$100 – ($90 + $2.50) = $7.50].

HOW WILL SHAREHOLDERS KNOW?

The corporation, mutual fund, or stockbroker will provide shareholders the information they need on the end-of-year tax statement sent every January.  That statement will tell shareholders: (1) how much of the dividend is tax-free; (2) how much of the dividend, if any, is taxable; and (3) how much shareholders can add to what they paid for the stock to determine their tax when they sell their stock.  Shareholders won’t have to worry about computing these amounts because it will be done for them on the end-of-year statement.

WHAT ARE THE ADVANTAGES?

Here are some of the advantages of the President’s proposal:

• Roughly 35 million American households currently receive taxable dividends.  Most of them will benefit.

• About one-half of taxable dividends go to senior citizens, many of whom depend on that income.

• Corporations that previously had a reason not to pay dividends will now have a good reason to pay them.

• Dividends are frequently considered a good way to judge if a corporation is healthy.  The current tax system disfavors dividend payments.  Under the President’s proposal, taxes would not affect the decision to pay dividends or retain earnings.  

• Corporations will have a good reason to pay taxes and not to engage in aggressive tax planning.  A dollar in taxes saved by a corporation no longer translates into more cash for their shareholders.  The less tax paid by a corporation, the less tax-free cash that can be paid to its shareholders.  That is good for the tax system.

• This puts us on a more equal footing with our biggest trading partners.  Most of them provide some relief from the double tax on corporate earnings, so the U.S is now at a disadvantage.

CONCLUSION

The President’s proposal makes sense for shareholders and corporations.  It will reduce huge distortions and inefficiencies, allowing corporations to make decisions based on what makes good business sense instead of what makes good tax sense.  It will reduce the incentive for tax shelters.  It may improve corporate governance by making corporate decisions more transparent and subject to shareholder scrutiny.  In short, it changes the math, and that has the potential to alter the way corporate America operates.