The recent media and congressional focus on corporate scandals and bankruptcies has overlooked one very important factor: the role of the U.S. tax code. Not only does the tax code encourage companies to finance their operations more through issuing debt (bonds) than by raising equity (stocks), but it also induces them to retain rather than distribute profits to stock investors through dividend payments. The tax code permits companies to deduct the interest paid on bonds but not the dividends paid to equity investors.

By distorting incentives and rewarding companies that took on too much debt or did not pay out dividends, these two undesirable characteristics of the tax system have contributed directly to the recent corporate business and accounting problems.

Corporate managers should make decisions for business reasons, not because of the tax code. To address these problems and remove the code from the decision-making process, Congress should make the tax system neutral with respect to financing through debt vs. equity and retaining vs. distributing corporate profits. Such changes would make the code fairer and benefit investors and workers by fostering more jobs and higher wages.

The Code's Bias in Favor of Debt

Companies are financed either by issuing debt or by raising equity. Bondholders in effect lend money to companies for which they receive regular interest payments until the return of the principal they had "lent." As long as companies can make these payments, bondholders are not affected by corporate performance.

Stock investors, by contrast, do not lend money to companies; they purchase a share of the business and become partial owners. Consequently, stock investors' fortunes rise and fall with the fortunes of companies.

There are inherent pros and cons for companies in raising money through both equity and debt. Bondholders generally demand lower overall returns, but they require regular payments. Equity investors usually seek higher total returns, but they are willing to accept lower regular dividend payments and uncertainty over the timing of their remaining returns. Businesses should arrive at the appropriate mix of debt and equity based on their own circumstances and evaluation of market conditions without being influenced by the tax system.

The differential tax treatment that favors debt over equity financing leads companies to take on more debt than they would otherwise. This overleverage causes problems, because companies must pay bondholders regularly (usually every six months) and cannot lower bond interest payments. During a business slowdown, bond payments compound corporate difficulties. With equity investors, by contrast, companies can lower or even suspend dividend payments during tough economic times.

Additionally, despite the tax deductibility of bond interest, bond payments tend to be substantially greater than dividends and, consequently, represent a greater corporate burden. Stock investors also generally anticipate additional returns from an increase in the company's share price.

Overleverage increases the financial load companies must bear. During a strong economy, this situation is not an obvious problem, but during a slowdown or recession, the weight of excess debt can be crushing. Some of the recent bankruptcies resulted from such overleverage.

The Code's Bias in Favor of Retaining Profits

When companies have profits, they choose between distributing them to shareholders through dividends or reinvesting the money in the company. Corporate managers should decide what to do based on the demands of investors, the needs of the company, and an evaluation of market conditions.

Here, too, the tax code distorts the decision-making process. The government taxes dividends people receive as ordinary income, with the top statutory tax rate approaching 40 percent, after first having taken money through corporate income taxes.

For example, if a company earns $100 profit, the government takes $35 (at the top tax rate of 35 percent). If the company distributes the remaining $65 as dividends, the government then taxes the person who receives it. At a hypothetical 30 percent individual tax rate (rates range from 10 percent to nearly 40 percent), the government would take another $19.50 from the $65. Of the original $100 profit, the government would have taken $54.50--and the effective tax rate on investors receiving dividends would be an astounding 54.5 percent.

If the company reinvests the profits in itself, its stock price will rise. Investors will not have to pay additional taxes until they sell the company stock for a capital gain. Even then, the government taxes capital gains at rates lower than ordinary income tax rates. (When correctly including corporate taxes in the computation as in the above example, taxing capital gains still represents an additional and counterproductive layer of taxation on investment.)

The unequal tax treatment of dividends and capital gains creates a bias for companies to retain rather than distribute profits. This prejudice causes trouble, because dividends are a concrete signal to investors of the financial health of companies. Strong companies pay increasing dividends. Weak companies cut or eliminate dividends. Without dividends, investors must rely on uncertain forecasts of future company profits.

Dividends are tangible, and all the accounting gimmicks in the world cannot fake cash payments to investors. The same cannot be said of forecasts of future earnings. By discouraging dividends--both to investors and, in response, to companies--the tax system increases the incentives to companies to retain profits. This circumstance makes it more difficult for investors to gauge corporate health accurately and makes it not just acceptable, but in fact desirable, for companies to pay low or even no dividends.

Because of the bias against dividends, the absence of dividend payments ceases to be a warning sign to investors. Weak companies can still prosper by using questionable tactics to prop up their stock price artificially. If the tax code did not discriminate against dividends, weak companies would not have this option.

The tax incentive to retain profits causes additional problems for companies. The excess retained cash (money that companies would have distributed as dividends if there were no tax bias) allows managers to invest in less desirable projects--either riskier or less profitable--than they otherwise would have undertaken. Keeping more profits in the company also may foster more wasteful corporate spending. Moreover, by punishing dividends, the distortion in the tax code encourages corporate executives to engage in various stock schemes to inflate short-term stock prices so that they benefit financially from the temporary increase.

Many of the companies that have been in the headlines because of their problems--such as Enron, Global Crossing, and WorldCom--followed the predictable path encouraged by the tax code. They took on more debt than they could repay--and tried to hide the debt--and paid little or nothing in dividends so that investors had to rely on financial forecasts.

The Need for Tax Neutrality

There are several ways to strengthen companies by resolving these damaging tax biases. One uncomplicated and effective step would be to abolish the corporate income tax entirely, thereby eliminating a harmful and excess layer of taxation while at the same time dramatically simplifying the tax system. The change would substantially decrease the tax prejudice against equity and in favor of debt. Taxing dividends at the capital gains tax rate would then remove the preference for retaining rather than distributing profits.

Alternatively, corporations could be allowed to deduct dividend payments. This policy, though, would markedly complicate corporate taxes. Moreover, by failing to address the bias caused by taxing corporate profits and capital gains, this approach would tip the scales in the other direction. It would create a tax bias in favor of distributing rather than retaining profits.

Another idea would be to eliminate taxes on capital gains and dividends. This policy would greatly simplify individual taxes and significantly lower the bias against equity while eliminating the incentive to retain rather than distribute profits.

Even just taxing dividends at the capital gains tax rate would be a step in the right direction because the current unequal tax treatment of capital gains and dividends influences investors to desire capital gains more than dividends. (Not taxing a given dollar amount of dividends--say, $400--as has been the case in the past would not be as effective a policy. This move would complicate the tax code and would not address the bias against dividends for many investors.)

Conclusion

Policy reforms--such as lowering the corporate tax rate and tax rate on dividends--that decrease the tax bias in favor of debt vs. equity financing and retaining vs. distributing profits would limit the likelihood of future corporate bankruptcies and scandals. 1 Such changes not only represent good tax policy; they would be positive developments for investors, companies, workers, taxpayers, and the economy.

-Lawrence Whitman was formerly the Director of the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

ENDNOTES

1. For more detailed discussions of the effects of tax policy on corporate activity and investment and other related issues, see F. Modigliani and M. H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review, Vol. 48 (1958), pp. 261-297, and "Corporation Income Taxes and the Cost of Capital: A Correction," American Economic Review, Vol. 53 (1963), pp. 433-443; R. Masulis and H. DeAngelo, "Optimal Capital Structure Under Corporate and Personal Taxation," Journal of Financial Economics, Vol. 8 (1980), pp. 3-29; M. C. Jensen and W. H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure," Journal of Financial Economics, Vol. 3 (1976), pp. 305-360; S. Fazzari, G. Hubbard, and B. Petersen, "Financing Constraints and Corporate Investment," in William C. Brainard and George L. Perry, eds., Brookings Papers on Economic Activity, Vol. 1 (Washington, D.C.: Brookings Institution, 1988), pp. 141-204; and Joint Economic Committee, Federal Individual Income Taxes and Investment: Examining the Empirical Evidence, June 2002. See also Daniel J. Mitchell, Ph.D., "Corporate Expatriation Protects American Jobs," Heritage Foundation Executive Memorandum, forthcoming.