Obama's Plan to Tax Dividends is Wrong, It's Time to End Double Taxation

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President Obama is outraged again.

These days he’s bothered by the fact that dividends are taxed at only 15%.

And to make people like Warren Buffett happy he wants to make dividends fully taxable at a top rate of 39.6% (plus state and local taxes.)

At the same time, he’s also talking about reducing the top corporate tax rate from 35% to 28%.

As dividend-earning shareholders, that means we must unite and also demand an end to subsidizing corporate fat cats by having our dividends taxed twice! 

Even if the corporate tax rate is reduced to 28%, our dividends – if subjected to the full income tax – will be taxed at a much higher rate than any other form of income.

First at 28% on the corporate level, then at another 39.6% for individuals, making the total tax rate on dividends 1-(0.72x0.604) or 56.5%!

That’s ridiculous, and totally unfair.

The Double Taxation of Dividends is Wrong

It’s also very damaging to our economic system—even though modern financial theory has downgraded the importance of dividends.

In reality, this “theory” is quite wrong.

That’s because the return on our investments is based on the streams of cash corporations can be made to pay.  In a business that is not liquidating itself, most of that cash comes in the form of dividends.

Companies that do not pay them can defer their shareholders’ returns ad infinitum. 

For their investors, the buying and selling of these shares in the market is simply a series of attempts to profit from the “greater fool theory.”

Take Apple Inc. (Nasdaq: AAPL) for example.

What you don’t know is that Apple’s $100 billion in cash is actually doing a great disservice to its shareholders.

After all, study after study has confirmed what Harvard professor Mike Jensen told us in 1986: A pile of cash is damaging to the company that has it.

It’s counter-intuitive but it’s true.

A large pile of cash tends to take management’s mind off the existing business, often causing them to fritter the money away in loss-generating acquisitions. 

It’s one of the reasons why it’s important to encourage companies to pay shareholders a decent dividend.

Today the double-taxation of dividends is still one of the hurdles keeping investors from getting their fair share.

Even at the Bush-inspired rates of 2003, the current system taxes dividends at a corporate rate of 35% followed by another 15%.  

The total is 45.3%, which is far more than the system taxes any other form of income. Again, that’s before state and local taxes.

That is a bias that needs to be reversed. 

But we shouldn’t do it by taxing dividends at zero to the individual. That would merely prompt left-wing politicians to denounce dividend-receivers as millionaire parasites.

Make Dividends Tax-Deductible For Corporations

Instead, dividends should be made tax-deductible from corporate income taxes, but fully taxable to individuals.

That would make dividends taxable at 35% currently or 39.6% if the Bush tax cuts are reversed – which is well below their current overall tax rate, but not a rate that could make dividend recipients seem privileged compared to those with other forms of income.

More importantly, if dividends were fully tax-deductible to corporations, there would be no excuse for companies to retain earnings, like Apple does.

Apple itself, for example, would pay an annual dividend of its full earnings of $35.14 per share (giving its stock a yield of around 7%) plus a substantial chunk of its existing $100 billion of cash.

It would do so because their shareholders would make them do it.

Here’s why.

Dividends taxed at zero on the corporate level would be worth more to shareholders than money taxed at the 35% corporate rate.

The point here is that retaining earnings makes net asset value rise and should make the share price rise (though won't if shareholders think they won't get the money.) But if you've lost 35% of the money in corporate tax, you're worse off even if the capital gains tax is lower than tax on dividends.

Tax-deductibility for dividends would also eliminate the corporate incentive for tax shelters, or for keeping money abroad.

A leasing deal that reduced the tax rate to zero on part of a company’s earnings would be less attractive to shareholders than getting that money in cash.  At the same time, cash parked in the Cayman Islands would be less attractive than cash parked in shareholders’ pockets.

Of course, some companies would try to ignore shareholders’ interests in this respect, but a few high-profile cases from the trial bar would quickly bring these recalcitrants into line.

The fact that George W. Bush didn’t do this when he reformed dividend taxes in 2003 was one of the first things that convinced me the man wasn’t very bright – Harvard Business School degree or not.

As for the current President, maybe he doesn’t understand the issue as he should, though I don’t know why.

The solution to his irritation isn’t complicated.

In fact, this year shareholders should unite and petition Presidential candidates, Representatives, Senators, anyone else we can think of (the Supreme Court ought to be helpful somehow!) to end this practice.

That way, we can get corporate dividends made tax-deductible.

And finally put an end to corporate fat cats that love to hang on to our money!

 

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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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