Fault the Tax Code for Low Dividend Payouts

Reducing the marginal tax rate on dividend income was not the optimal modification of the tax code. The U.S. corporate tax code continues to favor debt over equity because corporate interest payments are tax deductible whereas dividend payments are not. The recommendation in this article is that dividend payments be deductible at the corporate level and fully taxable to investors at their marginal income tax rates. The benefits should be a decline in debt financing and bankruptcy risk, substantial increases in dividend payouts, fewer stock option grants to managers, a decline in the equity risk premium, and higher stock valuations. Reducing the marginal U.S. tax rate on dividend income was a move in the right direction but not the optimal modification to the tax code. The intent of the legislation was to reduce the double taxation of dividends, which was accomplished. But the real problem is that the U.S. corporate tax code continues to favor debt issuance over equity issuance because corporate interest payments are tax deductible whereas dividend payments are not. We recommend that dividend payments, as well as interest payments, be deductible at the corporate level and be fully taxable to investors at their marginal income tax rates. Our proposed change in tax law would have numerous benefits: Debt financing should decline because debt's tax incentive will have been eliminated. Less debt would lead to lower bankruptcy risk. Dividend payout ratios should increase substantially. Failure to pay out dividends would give rise to corporate income taxes that otherwise could be avoided. Shareholders would receive more of their returns as dividends and less as capital appreciation. If capital appreciation is modest, then the value of incentive option grants diminishes, which should bring about a decline in the abuses associated with these options. If dividends increased substantially, corporate managers would be forced into the capital markets to raise equity capital to finance expansion. If investment bankers acted as underwriters, they would have to ensure that all is well at the issuing companies because the bankers would have their own capital at risk. Even with equal tax rates on capital gains and dividends, as now exist, companies may not increase dividends because investors can defer capital gains taxes whereas taxes on dividends have to be paid when the dividends are received. Our recommended modification to the tax code would force companies to increase