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June 03, 2012 The Tax Lawyer

The Case for Dividend Deduction

Vol. 65, No. 1 - Fall 2011

Reuven S. Avi-Yonah & Amir C. Chenchinski


    The December 2010 compromise between President Barack Obama and the Republicans extended the 15% tax rate on dividends through the end of 2012. At that point, however, the rate may revert to the Clinton administration rate—39.6%—or be raised to 20%—as proposed by the Obama Administration. Thus, the United States may either abandon corporate-shareholder integration, maintain partial integration, or perhaps even adopt the George W. Bush administration’s 2003 proposal to exempt dividends altogether—as advocated by some Republicans in Congress.

    Given this uncertainty and the likelihood of additional Congressional action, now may be a good time to revisit the integration issue. Another reason for revisiting the topic is that several recent proposals would restrict the deductibility of interest at the corporate level as a way of reducing the pressure on the distinction between debt and equity, which was also a reason to adopt partial integration in 2003. The President’s Economic Recovery Advisory Board has identified integration as a top policy priority in its report on options for federal tax reform.

    Traditionally, three reasons have been given to adopt some form of corporate–shareholder tax integration. The classical system of corporate taxation, under which corporate income is subject to tax and dividends are not deductible and are fully taxable to shareholders, leads to three distortions. First, there is a bias against operating as a “C” corporation because only C corporations—typically, publicly traded corporations—are subject to the double tax. Second, there is a bias against dividend distributions—which trigger the double tax—and in favor of earnings retention or distributions in the form of capital gains—which are subject to tax at a lower rate. Third, there is a bias against equity and in favor of debt because interest is deductible and dividends are not.

    When the Bush Administration proposed to exempt dividends from tax in 2003, they argued—in accordance with the 1992 Treasury Report—that such a move would reduce all three distortions. If the corporate rate and the individual rate are the same, then for taxable United States shareholders, a dividend exemption would mean that there is no bias against the corporate form because income earned through C corporations and income earned directly or through pass-through entities would be subject to the same rate. The bias against dividend distributions would be eliminated because dividends would not trigger tax at the shareholder level. Finally, the distinction between debt and equity would matter less because interest would be taxable to the recipients of the interest payments while dividends would be taxable at the same rate at the corporate level.

    It is not clear whether the 2003 change, as enacted, achieved any of these goals. The bias against C corporations remained to the extent that shareholders are tax exempt because they may bear the burden of the corporate tax but are not taxed on noncorporate income. The bias against dividends may have been mitigated, but the data indicates that dividend distributions did not increase more rapidly after the 2003 change, while redemptions did grow dramatically. Finally, the debt–equity distinction remained in place because interest could still be deducted and recipients were frequently tax exempt, while dividends could not be deducted. In the hands of taxable recipients, therefore, equity was still taxed more heavily than debt even though dividends were subject to a lower rate than interest.

    However, proponents of integration would argue that we simply did not try hard enough in 2003, both because we only partially exempted dividends and also because there is a better, more thorough, integration alternative. This is the Comprehensive Business Income Tax (CBIT), first proposed in the 1992 Treasury Report.

    Under the CBIT, all business entities—whether incorporated or not—are subject to a business level tax at the same rate. Dividends and interest are both nondeductible but are exempt at the recipient level. This solution directly takes care of all three of the biases. First, there is no distinction between C corporations and other business entities, eliminating the bias against the corporate form. Second, there is no tax on distributions of any kind, which eliminates the bias in favor of retention. Finally, since dividends and interest are both nondeductible, there is no debt–equity distinction.

    In recent years, various proposals have built on the CBIT concept. Edward Kleinbard proposed the Business Enterprise Income Tax (BEIT). The BEIT differs from the CBIT primarily because it permits all business entities a deduction for a Cost of Capital Allowance (COCA) reflecting the “normal” return on capital, which is taxable at the investor level. Dividends and interest are not deductible or includible under the BEIT.

    The Bush Tax Reform Advisory Panel proposed the Growth and Investment Tax (GIT), a business level cash flow tax under which all capital expenditures are deductible, as are wages, but dividends and interest are nondeductible but are subject to a 10% rate at the recipient level. The Obama PERAB proposals also envisage applying corporate taxation to a broader class of entities.

    All of these proposals seek to achieve the same integration goals as the CBIT, although the GIT goes further by effectively converting the business tax into a consumption tax or a value added tax (VAT).

    In our view, the problem with all of these proposals is that they omit to ask the crucial question: Why should we tax business entities in the first place? Taxes—the economists tell us—are always borne by human beings and not by legal entities. Why should legal entities, be they corporations or another form of business entity, be subject to tax at all? Would it not be easier just to tax people?

    It turns out that there are two good reasons to tax some business entities under some circumstances. Specifically, publicly traded corporations should be subject to tax. First, it is hard to tax them on a pass-through basis and if they are not taxed they become vehicles for tax deferral. Second, they are economically important, and taxing them is a means to regulate the behavior of the people who run them.

    However, if those are the reasons for taxing business entities, then we believe that the right form of achieving corporate integration is not the CBIT or its progeny, dividend exemption, or imputation—giving shareholders a credit for the corporate tax. The right form of integration, we argue, is dividend deduction.

    Dividend deduction is frequently mentioned in the literature on integration but rarely analyzed. In what follows, we will try to explain why dividend deduction is a superior form of integration and resolve some of the hard questions dividend deduction raises. One such question is why, unlike dividend exemption and imputation, dividend deduction has not yet been tried anywhere, as far as we know—although several countries have adopted a lower rate for distributed than for retained earnings.

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