In the wake of the stock market meltdown and a shaky economy,
George W. Bush has proposed eliminating the double taxation of
dividends. While most of the discussion has focused on the impact on
near-term economic growth and stock prices, the greater significance
of this policy change for the economy may be on long-term corporate
Done properly, it would change how corporations compete.
Eliminating the bias against dividends would markedly improve
company strategies by better aligning them with true economic
fundamentals. Sounder strategies that result in better utilisation
of capital in the economy are the best way to restore confidence in
In the current system, paying dividends is tax-inefficient.
Instead, the motivation has been to plough retained earnings and
even borrowed capital into expansion and acquisitions. With
shareholder value the overriding focus of management, and equity
dominating executive compensation, growth became the overarching
goal of most companies. Dividends were passť and dividend pay-outs
fell. With little or no dividend pay-out, share prices were driven
largely by growth expectations.
This encouraged too much debt and other dubious financial
practices but the biggest cost was in corporate strategy. The bias
towards growth and against profits and dividends lies at the root of
many of the strategic blunders and corporate scandals that have
recently come to light, as well as the disappointing profit
performance registered by so many companies.
The growth imperative led companies to seek market share at all
costs, often destroying the profitability of their entire industry.
It also drove diversification into questionable new fields and
encouraged acquisitions that created no economic value, while
providing opportunities to manipulate reported earnings. Examples of
such strategies include WorldCom (market share at all costs), AOL
Time Warner (growth justified by illusory synergies), Cisco
(expensive acquisitions for growth's sake) and Disney (ill-advised
attempts to grow beyond its areas of competitive advantage).
Ending double taxation of dividends would go a long way towards
restoring sound strategic thinking in a way that corporate
governance reform and ever more intricate accounting rules alone
cannot accomplish. In a world no longer biased against dividends,
strategies that maintain a clear business focus, earn attractive
profits and pay them to shareholders would be rewarded.
Companies would be able to provide attractive investor returns
without depending on uncertain stock price appreciation. Company
moves to grow faster than their industry by buying market share
would be penalised rather than encouraged. Forays into new segments
or new businesses without a compelling competitive advantage would
look far less attractive.
Mergers to pump up growth, arguably the greatest destroyer of
shareholder value over the last few decades, would be received
warily by investors (though doubtless still marketed heavily by
fee-driven investment bankers). Growth would still matter but only
in the context of acceptable risk and profitability. Some industries
and companies would continue to be growth-driven but this logic
would not be foisted on businesses that had modest underlying growth
Attempting to police management decisions through corporate
governance and reporting reforms, without changing the underlying
incentives leading to poor corporate choices, will result only in an
endless cycle of more and more intricate rules and regulations. Far
more effective would be a shift to rewarding profits paid regularly
to shareholders that aligned decisions with true economic value. In
virtually every recent corporate failure, an imperative to pay out
real cash would have done wonders in clarifying the management's
To reap the greatest benefit from this policy change, the tax
exemption should be at the corporate, not the individual level. A
corporate exemption would more directly influence management
choices, would probably be less costly owing to offsetting taxes on
elevated pay-outs and would help eliminate uneconomic corporate tax
avoidance tactics such as moving corporate headquarters to Bermuda
and formulating complex transfer pricing schemes.
A corporate exemption is likely to benefit everyone, because its
effects would almost certainly be passed on to consumers via lower
prices. Since individuals with lower incomes tend to have the
highest rates of consumption as a percentage of income, an exclusion
at the corporate level is likely to be far more progressive than one
that benefits only stock-owning individuals. And the last thing the
US needs is another personal tax exemption in a system already far
Sceptics who label the proposal a gimmick, or a tax break for the
rich, fail to grasp the benefits of lower corporate taxes for
everyone and miss the larger point. A dividend exemption, especially
at the corporate level, would have sustained benefits for investors
and workers alike. And it might just be a relief for managers, many
of whom have felt trapped in a system that creates intense pressures
to make questionable decisions.
The writer is Bishop William Lawrence university professor at
Harvard Business School