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NATIONAL CENTER FOR POLICY ANALYSIS
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Disappearing Dividends
Daily Policy Digest

Tax Issues / Behavioral Effects of Taxes

Monday, August 05, 2002
According to Bruce Bartlett, a key way shareholders exercised control in the pre-corporate tax era was demanding that firms pay large cash dividends. Among other things, this helped guarantee that corporate earnings were "real" and not based on creative accounting.

However, once the corporate income tax was imposed, shareholders realized that it was better for profits to be kept within the corporation. Shareholders could get their earnings in the form of capital gains, rather than dividends. Not only are capital gains more lightly taxed than ordinary income, but also shareholders themselves decide when to pay the tax, since capital gains taxes are assessed only when shares are sold.

This has led to a steep decline in the number of companies offering dividends. According to economists Eugene Fama and Kenneth French:

  • The percentage of large companies paying dividends in a given year has fallen from 68.5 percent in 1978 to 21.3 percent in 1998 (see figure).
  • Over this same period, the dividend yield fell from 5.28 percent to just 1.49 percent.
Shifting away from dividends has had several consequences:

  • Without the need to come up with hard cash to pay quarterly dividends, corporate managers have much more flexibility in how to present a company's performance to shareholders - increasing the opportunities for shady accounting.
  • Additionally, since interest payments are tax-deductible, companies are now issuing bonds, instead of stock, to generate cash.
  • This makes companies more vulnerable to economic downturns and often pushes them into bankruptcy, because interest payments cannot be reduced or suspended when profits fall, but dividends can.
Barlett argues that it makes no logical sense why two businesses of equal profitability should pay sharply different tax rates on their earning based solely on their legal form of organization.

Source: Bruce Bartlett, senior fellow, National Center For Policy Analysis, August 5, 2002.

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