President Bush's Tax Plan
Will Tax-Exempt Dividends make a Difference? — an interview with Professor Steven A. Bank of Florida State University College of Law
Brian Mabee | University of California, Davis, School of Law
Eli Makus | University of California, Davis, School of Law

Posted Wednesday, January 1, 2003
3 U.C. Davis Bus. L.J. 1 (2002)

Professor Steven A. Bank is an Associate Professor at Florida State University College of Law and is currently a visiting professor at the UCLA School of Law. Professor Bank is a leading tax scholar and is especially concerned with the issue of double taxation in the business context. He recently published "Corporate Managers, Agency Costs, and the Rise of Double Taxation" in the William & Mary Law Review and is the author of "Is Double Taxation a Scapegoat for Declining Dividends? Evidence from History," which is forthcoming in the Tax Law Review. In addition, he was recently interviewed on CNBC's Squawk Box about President Bush's tax proposal.

During a recent conversation, Professor Steven Bank weighed in on the cornerstone of President George W. Bush's $695 billion tax cut proposal: eliminating double taxation of corporate income. After five minutes with Professor Bank, a visiting professor at UCLA, it is clear why double taxation of corporate income is bad business policy. Equally clear, however, is that Mr. Bush has overstated the benefits of his proposal and failed to address some key issues. To help unpack President Bush's proposal, Professor Bank first explained why double taxation of corporate income is widely viewed as bad policy.

First, it is unfair. Business income is taxed twice when it is earned through the corporate form, but only once when earned in another form, such as in a partnership or sole proprietorship. While double taxation of income occurs in other areas of the tax code, this incongruous tax burden among business forms is unique. Furthermore, the corporate income tax is a flat tax overlay on a progressive individual income tax system and therefore overtaxes shareholders in lower brackets while under taxing shareholders in higher brackets.

Second, and key to the debate, double taxation creates inefficiencies in investor decision-making. The tax gives investors an incentive to avoid dividends where they may have otherwise been welcome. By and large, the tax system strives for neutrality-neither encouraging nor discouraging one investment over another. Yet, the current policy may, for example, encourage entrepreneurs to choose a partnership model over a corporate model even though in many cases setting up a corporation would make better business sense. The tax also creates incentives for corporations to finance operations through acquisition of debt, rather than equity. Money that flows out of the corporation as interest to bond holders is only subject to one layer of tax because it is deductible by the corporation. Dividends, on the other hand, are subject to the double tax. Thus, this tax structure encourages corporations to take out more debt instead issuing equity shares. In the same vein, double taxation encourages corporations to retain earnings rather than issue dividends because retained earnings are only taxed once. The result is that tax avoidance strategy, rather than market forces, determine who gets to control corporate earnings.

In the wake of Enron, many commentators also argue against double taxation because of its negative effects on corporate governance. As a general proposition, corporate earnings are subject to less independent oversight than, say, institutional loans or stock offerings. Creditors and investors are likely to observe and oversee corporate activity to some degree in order to protect their investment. If, on the other hand, managers finance operations by using corporate earnings, opportunities for corporate waste increase significantly. Stated another way, managerial freedom may encourage, or at least permit, questionable accounting practices in order to portray favorable earnings as Tyco and Enron are accused of doing.

If all this is true, then why is President Bush's tax plan, which would eliminate the double tax on corporate earnings, not the perfect solution? Professor Bank emphasizes that when evaluating this plan, it must be taken in context. If the question is "should we integrate corporate and dividend income taxes," the answer is yes. Eliminating inefficiencies and moving toward a neutral tax system is a laudable goal. But President Bush has framed the plan as an economic stimulus measure, and whether it will prompt sustained growth and deliver broad tax relief is less than clear.

President Bush proposes what Professor Bank terms a partial integration measure. This means corporate profits and individual dividend income taxes will be integrated into one tax structure. The important caveat, making it only a partial integration, is that not all dividend income tax will be excluded: only in those situations where the dividend income has previously been taxed at the corporate level.

Ultimately, Professor Bank questions whether this plan will provide the economic benefits promised by President Bush. Although dismantling the double-tax would remove inefficiencies, which may result in some economic gain, the larger question of whether it would provide any significant economic stimulus remains unclear. Although proposals for eliminating the double-tax have been around since the Ford administration, (and proposed by Presidents Carter, Reagan, and George H.W. Bush) this is the first time the plan has been trumpeted as a key element in a tax cut designed to stimulate the economy. Though Reagan proposed this change in the context of a tax cut in 1986, it was realistically just one aspect of an effort to broaden the tax base and simplify the tax system. By eliminating exclusions and exemptions such as this, overall tax rates could be lowered.

President Bush puts this plan at the core of his economic stimulus package, claiming that the tax cut will not only infuse the economy with cash, but will also jumpstart the stock markets. Professor Bank says that while this may be true to some extent, the boost may only be temporary and the actual effects negligible. Based on the stock capitalization theory, stock prices reflect the cost of double taxation. Thus, when the double-tax is eliminated, a windfall will result for existing stockholders. But this will only be a temporary bump for stock prices and the benefit will only go to existing stockholders; secondary purchasers will buy at the new, adjusted price. At best, the tax break is likely to provide a psychological jolt to the economy rather than a substantive stimulus.

As for the plan's corporate governance benefits, Professor Bank believes this is a particularly dubious argument. If managers want to refrain from giving dividends, they will lobby for tax provisions that meet their goals. Historically, corporate managers have proven a formidable lobby, particularly vis a vis shareholders, whose interests are diffuse.

Even if this plan is successful in delivering on its promised goals, Professor Bank questions whether this is the right time to propose a deep tax cut. This is the first time in the face of military action that a president has promoted a tax cut. Usually, taxes go the other direction. In 1916, for example, the highest marginal tax rate was 15%, but by 1917, it was 65%. Professor Bank notes that some argue this is because Democrats have always been in power when we have gone to war and that Republicans would fund a war through other means, such as by borrowing money.

In the end, Professor Bank suggests that even if a measure were passed that aligned corporate and dividend tax rates, they could quickly become unaligned through lobbying efforts. That was the eventual result after the 1986 plan passed. The capital gains preference was eliminated for a while, but the Clinton administration effectively re-established it. Similarly, given the strong lobbying position of management, there is unlikely to be a stable integration system for any substantial period of time.

In summary, Professor Bank focuses on what integration of corporate and dividend taxes will really accomplish. It will remove the inefficiencies between corporations and partnerships, clearing the way for people to choose an organizational structure without the distortion of double taxation incentives. This plan probably will even provide a short boost to the economy as current shareholders experience a windfall before prices adjust to non-dividend tax levels. However, Professor Bank remains skeptical that this plan will meaningfully improve corporate governance or provide any sustainable strength to the economy. In the end, Professor Bank suggests this plan may reflect less of a desire to stimulate the economy, and more of a tendency to favor consumption tax over income tax. As he notes, the dividend exclusion plan taken together with the other major component of President Bush's tax proposal: consolidation of savings plans under a tax-free umbrella, and the system has moved some distance toward an overall consumption tax philosophy.

Eli Makus and Brian Mabee are second-year students at the University of California, Davis, School of Law.