Dividends as Corporate Reformer

Daniel Yergin, chairman of Cambridge Energy Research Associates, is co-author of "Commanding Heights: The Battle for the World Economy" and executive producer of the PBS series of the same name.

Critics of President Bush's proposal to eliminate double taxation on dividends overlook a simple fact. Ending the double tax would greatly contribute to the reform of corporate governance, which has been high on the national agenda since Enron and WorldCom went bust. Dividends are second-class citizens when it comes to investing. Changing that would have a more positive impact than a host of new regulations. It would also help improve the retirement prospects for the tens of millions of Americans who are counting on the stock market, directly or indirectly, to finance their senior years.

Capital gains -- what you make when you sell stock -- are taxed at 20%. For every dollar of gain, 20 cents goes to the Internal Revenue Service, and the remainder (minus state tax) goes to the seller. But dividends are taxed twice: first, a corporation's net earnings, from which dividends come, are taxed at a 35% rate; then an individual receiving the dividend is taxed on it up to almost 40%. What this means is that for every dollar of dividends, about 60 cents goes to the federal government, and 40 cents or so to the dividend collector.

This distortion creates two incentives: one, to drive up stock prices, and, two, to minimize dividends.

This, however, was not always the case. For many years, shareholders wanted income in the form of dividends. They were a mainstay of investment. Over several decades, the stock market registered average annual returns of around 9%. About half of that was from dividends.

But in the levitating markets of the second half of the 1990s, stock appreciation was the name of the game. Capital gains were what investors wanted, and they couldn't get enough of them, which meant that stock prices had to be pushed ever higher. Corporate managers, fired up by the cult of quarterly performance and armed with options, were eager to boost the stock price of their company. The nature of this game was to provide an opportunity for oversized gains for those richly endowed with options -- and, for some, the temptation to bend and stretch the rules way out of bounds.

Dividends became less and less important, to the point of near-irrelevance. They were even a subject of ridicule. Yields declined from 5% or 6% to 2% or under. Dividends were associated with prudence, which seemingly clashed both with the demand for quarterly performance and the exuberant spirit of the booming market. Corporate managers who did not want to play the capital gains game were regarded as fuddy-duddies; they became targets for replacement. And if not them, then their companies became takeover targets.

All this worked until the capital gains game ended. Three years of down markets have revived the forgotten lesson that markets do not always go up. They have also demonstrated the costs of the double taxation, both in terms of lost value and in terms of wrong incentives.

Dividends bring the pull of gravity to a levitating market. Unlike quarterly earnings, which can be managed, manipulated, restated or even falsified, dividends have a tangibility. They are paid in cash; they are a pact between the company and the shareholder. They are a check in hand, rather than a promise for the future. They provide a form of transparency for seeing how a company is doing.

But the current taxation gap between dividends and capital gains discriminates against dividends. Closing that gap by taxing dividends not twice, but only once, would improve the competitive position of dividends, making them a more realistic choice for managements. The imperative to play the capital-gains-quarterly-earnings game would correspondingly weaken.

This reform would get rid of another costly distortion. While dividends are double-taxed, interest costs on corporate debt are tax deductible. This is an obvious incentive for a company to take on debt to fund acquisitions or takeovers, which may or may not make good business sense. The collapse of WorldCom, in part the result of its huge debt-fed buying spree, is an extreme example of what can go wrong.

Eliminating double taxation of dividends would also broadly benefit the tens of millions of Americans with 401(k)s and other equity-based retirement plans. These days, many of them are not even opening the envelopes to see how their plans are doing. But their situation may be worse than they think. The current system assumes that, once retired, they'll all be market-timers: They'll know when to sell shares or mutual funds to raise cash. That's not easy to get right in up markets, let alone flat or down markets. The need to sell also undercuts a much-praised principle of investing: holding a stock for the long haul.

Dividends provide an alternative. Even tax-free retirement accounts would benefit from a system that reemphasized dividends. For it would be significant to see more income -- dividends -- flowing into retirement accounts, and then into the hands of retirees. But that won't happen until the tax imbalance is righted and full citizenship is once again accorded to dividends in the realm of investment.

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