As Congress grandstands and points its fingers at dishonest corporate executives, I think we should examine what role Congress itself played in the recent destruction of investor wealth.
Foremost, the double taxation of corporate dividends is an abomination that Congress has written into the tax code. In one bold step, Congress could repeal this law, and, in a matter of weeks the market would enter a long term and sustainable rally!
When a corporation like Home Depot makes a profit, they must pay corporate income tax on that profit. Then, as some of the after-tax profit is paid out to the shareholders as a dividend; the money is taxed again at the stockholder's personal income tax rate. Thus, Congress has rigged the game to where the government is confiscating 50–70% of the wealth generated by corporations, leaving little behind for individual investors.
Both Enron and WorldCom were highly leveraged. Many corporations in America today are highly leveraged. Corporations are able to deduct interest payments on their tax returns but not dividend payments. The banking lobby loves this! Of course Federal Reserve member banks desire that there be every incentive possible in the tax code to get companies to borrow money.
Corporations, seeing that the government takes 50-70% of the wealth that they generate, will try to use the tax code to reduce their burden. Unfortunately, a number of companies borrowed enormous sums of money, and invested that money in huge, low-return infrastructure projects. WorldCom, for example, thought that by depreciating their fiber optic networks and deducting large interest payments, they could deliver a low tax enterprise that would grow in value and deliver capital gains to their shareholders.
Capital gains are a more efficient way to deliver gains to shareholders than dividends, as the tax rate is 20 percent versus 50-70 percent on double-taxed dividends. When WorldCom's business went south because of overcapacity and falling prices, management tried to hide their mistakes of too much debt and poor capital expenditures, with accounting.
If corporations were allowed to deduct their dividend payments, we would immediately see many hundreds of companies increasing the dividend payouts to shareholders. There would immediately be less incentive for companies to borrow money and invest surplus cash in boondoggle low-return projects.
Not that we should be concerned with this, but probably the government would not lose any income either, as the income on personal returns would increase, the deduction for interest expense would decrease (poor banks), and finally, capital gains would increase as companies that increased dividends would be rewarded with higher share prices.
We could get back to investing the old-fashioned way, looking at companies with secure and rising dividends. Most companies today would rather buy back stock with surplus cash, with hope of a rising share price, than pay a dividend because a capital gain is much less taxed reward for shareholders than a check in the mailbox.
Another reason to fix this disaster in the tax code is the coming retirement of the baby boomers. The baby boomers will need their investments to provide them with income. The payout ratio and dividend yield on the market is pitifully low because of the tax code. With higher stock payouts, there will be less wholesale liquidation of stock portfolios to meet income needs of the boomers.
Finally, this tax code hurts the American worker. Why should companies locate manufacturing here when the government will take so much of the earnings away from the risk takers who create the company? It is cheaper to manufacture in China and pay a flat 10% tax than to create new jobs taxed at a higher rate here at home. China understands the importance of low taxes. Congress does not. Does this seem as odd to you as it does to me?
July 24, 2002
Mike Meixler [send him mail], a former Army officer, is an investment representative for a nationally known NYSE member firm in Arizona.
