Do Away With Double Taxation of Dividends

Many economic Band-Aids will be proffered by the policy wonks at President Bush's confab in Waco Tuesday. One issue that isn't front and center -- but should be -- is the double taxation of dividends. Corporations pay taxes on profits, then, to the extent that those profits are paid to shareholders in the form of dividends, they're taxed again.

Lawmakers invariably get in their own way in their efforts to legislate a better society, especially when it comes to tax policy. The law of unintended consequences is fully operational when it comes to the taxation of dividends. Legislators don't realize that dividend taxation has contributed both to stock market volatility and to executive excess, harming individual investors.

Here's why double taxation on dividends should be eliminated:

It would make equity investing real for the individual investor.

If the receipt of dividends were tax-free, it's safe to assume that pressure on corporations would build quickly to return a reasonable portion of profits to shareholders.

Lots of companies are selling at 10 times earnings today, but many don't pay a dividend. That's partly because of double taxation of dividends. If those same companies paid out 30% to 50% of profits to shareholders, the appeal of equities as an asset class would grow considerably because many would be paying a tax-free income stream of 3% to 5%.

Individual investors have been burned badly by equities, scalded by hype and promise. It's time to get back to basics: cash. A stream of tax-free cash flow, in the form of dividends, would make the profits of companies real to individual investors. This is a subjective assessment, admittedly, but I think tax-free dividends would also translate into less volatility in the market, providing a higher valuation floor during periods of market weakness.

Executive excess is due, in part, to double taxation of dividends.

Drawing a causal link between taxation of dividends and executive excess and/or corruption may not make a lot of sense, at first blush. But we're not talking about direct causation. Executive excess is an unintended consequence, a by-product, of dividend taxation. By not returning profits to shareholders, too much capital builds up within companies, leading to waste, executive excess and, yes, corruption.

The last cycle was marked by a misalignment of interests: The interests of shareholders weren't aligned with the interests of corporate management. Corporate managers, with their bloated stock option programs, have been loath to return profits to shareholders for many years now -- keeping cash in the corporate till is in their best interests, after all, if they hold options.

But an end to taxation of dividends, coupled with restricted stock awards for executives, instead of options, would correct the misalignment of the last cycle. Executives would want to pay cash to shareholders if they received the same dividends (as holders of restricted stock).

The standard argument: Double taxation isn't fair.

This point is well known, so I don't need to rehash it in detail: If a corporation, owned by shareholders, pays tax on income, it shouldn't matter if the income is retained by the corporation or returned to the shareholder in the form of a dividend. It shouldn't be taxed again. Other forms of business structures, such as partnerships and sole proprietorships, don't have this double-taxation burden. It's indefensible that corporate America does.

While the media like to focus on CEOs and CFOs in handcuffs or other flashy news stories, now's the time to think about more mundane, systemic matters. The issue at hand for the Waco confab should be what can be done now to alter the landscape to benefit individual investors.

Here's an easy one -- as the late, great Chick Hearn would say, "a slam dunk." Tip the balance of power of cash management back to shareholders. Eliminate the inequity of double taxation of dividends and put an end to the unintended consequences that go with it.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.