Ending tax on dividends right thing to do

By DAVID MOON, Moon Capital Management
January 12, 2003

The cornerstone of President Bush's new economic stimulus package is an elimination of the personal income tax individuals pay on the corporate dividends they receive. Supporters, such as CNBC's madcap, Jim Cramer, hail it as the 'solution we've been needing to get this economy moving again.' Critics like the New York Times call it handouts for the rich, describing it as the 'Charles Schwab tax cut.' Both are wrong.

When politics and economics are intertwined, it is difficult to differentiate from people's stated and actual intentions. If the President or his economic advisors really believe that eliminating the taxes on dividends will propel the economy in 2003, they are less competent than even their critics will grant. Regardless of the impact of this tax elimination, it will not have any discernable impact on the economy this year.

By midweek, half of the political spinmeisters labeled this tax cut as a windfall for the top one percent of wage earners. Supporters countered that more than 90 million Americans would directly benefit from Bush's plan, each receiving about 1,000 dollars a year in tax relief. I really don't care which camp is more accurate; eliminating the tax on dividends is the right thing to do. The impact won't be immediate, but it will help the economy.

When a corporation makes money, it has three general options of what to do with those profits. But first, the company must pay taxes on those earnings. Then it can keep them and reinvest them into the business. Or it can pay down debt and make other types of changes to its balance sheet and capital structure. Or it can pass along those profits to the shareholders in the form of dividends. In reality, each of these three options is 'passing along those profits to the shareholders,' because the shareholders get the benefit of that accumulated capital, regardless of how the company chooses to deploy it. And in each case, the corporation pays income tax on those earnings. But if the corporation decides to return the money to the shareholders in the form of dividends, the profits are taxed a second time at the individual level, increasing the effective cost of capital for those businesses and their owners.

Anything we do to lower the cost of capital increases the effectiveness and productivity of the overall economy. Increasing the output of the overall economy is the only way to create real gains for the entire economy. Extending unemployment benefits may be humane and it does provide some people their only safety net. But shifting money from one group of citizens to another does nothing to increase the size of the overall economic pie. Lasting and widespread economic improvement occurs when the entire pie grows. That will be the effect of eliminating the taxes on corporate dividends.

All economic progress is the result of the application and allocation of the four forms of capital: natural resources, labor, money and human ingenuity. In order to permanently improve anyone's economic situation, we must apply more of one of these four factors of production. If you want to make more money, you need to strike oil, work harder, invest in something productive or successfully execute a new business idea. If a business wants to make more money, it has to do the same thing. So does a country. Anything that reduces the cost of any of these forms of capital improves both their efficiency and effectiveness.

If one of the frictional costs of corporate profits is eliminated, the cost of that capital is reduced. The fact that dividends are already taxed once only makes this a logical place to reduce capital costs. Based on what the politicians are saying, it seems they are doing the right thing ' but for the wrong reason.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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