Tax (Photo credit: 401(K) 2012)
The column below is a guest post from R. Cromwell Coulson, president and CEO of OTC Markets Group (OTCM), operator of the OTCQX, OTCQB and OTC Pink financial marketplaces for U.S. and global securities.
It is time we rebalanced our capital markets and strengthened our economy by fairly and equally taxing interest and dividends. Today, our tax code wrongly gives an economic advantage to interest payments on debt over dividends payments to shareholders. This debt bias is based on the accounting rationale that interest is a tax-deductible cost of doing business while dividends are a non-deductible form of business income. From an economic and investor standpoint, this distinction is unjustified, since interest and dividend payments both represent a return of capital to investors and should be treated equally.
As the CEO of a profitable, publicly-traded small company that pays dividends, and as an operator of financial marketplaces with more than 1,600 dividend-paying companies, I am keenly aware of the impact dividend tax rates have on corporate decision-making, capital allocation and economic growth. My company pays a federal tax of up to 35 cents on a dollar of taxable income. If we pay the 65 cents in after-tax income as dividends, our shareholders are taxed again at 15%.
This double taxation equals federal taxes of 45 cents on every dollar of taxable income paid as dividends (and total taxes of more than 53 cents in high tax states like New York). In contrast, when we borrow money, we can deduct those interest payments from our taxable income and the debt holder will be taxed just once at 35%.
Because of this discrimination against dividends, a profitable, cash-flow-producing public company like mine will return 65 cents of every dollar after taxes as interest to debt holders but only 55 cents as dividends to shareholders. Put another way, the after-tax return on a dollar of our taxable income is 18% higher if delivered as interest on debt than as dividends on equity.
Unfortunately, this situation is about to get a lot worse. Without action by the President and Congress, on January 1st the top individual tax rate on dividend income will nearly triple from 15% to 43.4%. With double taxation, this will result in effective federal taxes of more than 63 cents for every dollar of taxable income paid as dividends.
Reinvested dividends contributed almost half of the S&P 500 Index’s total return between 1929 and today. A high tax on this important source of income reduces the incentive to pay dividends and furthers the bias toward debt financing that inhibits corporate growth. Leveraged companies are less likely to invest in operations and take the risks that drive innovation and new jobs for our economy. Heavily indebted companies are also more vulnerable to economic shock and bankruptcy, increasing the risk and magnitude of any future financial crisis or recession.
Corporate boards can choose whether or not to pay dividends. High dividend tax rates will cause tax conscious boards not to make that choice, opting instead for other uses of free cash flow such as debt-fueled stock buybacks and acquisitions. Sadly, most management teams do not share Warren Buffet’s skill at investing excess cash and making acquisitions. Academic studies are rife with examples of companies that squander their investors’ money by buying back shares at the top of the market or overpaying for businesses and losing their valuable intellectual property and employees in the process.
Public companies pay a dividend because stocks are more attractive and easier to value if they produce income for their investors. Less income after tax will result in lower marketplace valuations and leave equity-rich companies more vulnerable to takeovers or leveraged buyouts.
Ironically, it is the private equity firms, whose business models Obama campaigned so hard against, that will profit from the Democratic Party’s tax plans. Backed by tax-advantaged debt, private equity firms will use our nation’s debt bias to cull the equity of profitable companies traded in our public markets. When dividends are taxed more than interest, not only do investors suffer, so do workers who desire financially strong employers and retirees who depend on dividend income that outpaces inflation.
Clearly, double taxing dividends has negative implications. The more efficient and effective approach is to allow profitable companies to return excess capital to their shareholders without subjecting those dividends to discriminatory tax treatment. Companies should be allowed to deduct dividend payments from their taxable income just like interest payments are deductible, and there should be one flat tax rate for interest and dividend income. Only then will we provide a level playing field for management and investors when considering different capital structures and investment strategies.
Rather than providing companies with incentives to take on more debt through stock buybacks, acquisitions or leveraged buyouts, our tax policy should encourage healthy growth and a strong economy through equity investments that can provide income to investors. We need a tax code that lets companies like mine fairly share success with our shareholders.
--R. Cromwell Coulson, president and CEO of OTC Markets Group
