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Dividends, Double Taxation of 95 Dividends, double taxation of 95 Dividends, double taxation of Retained earnings versus dividend payout Joseph J. Cordes One way corporations can reduce the sting of the George Washington University double tax is to retain earnings rather than pay them out in dividends. If the retained earnings are in- Taxation that comes about in the U.S. tax vested wisely by the corporation, each dollar of re- tained earnings should increase the value of the system because corporate profits are taxed firm, which raises its share price. Such price appre- once by the corporate income tax and then ciation translates into a capital gain for shareholders; again when these profits are distributed to and although capital gains are ultimately subject to shareholders. tax, they are taxed more lightly than dividends, mainly because of tax deferral. Although retained earnings are neither good nor bad in and of them- Income that is earned by corporations in the United selves, economists believe that the decision to retain States is currently subject to two levels of tax. Cor- earnings or pay them out should be based on nontax porate profits are subject to the corporate income considerations. tax. When these profits are distributed to the share- holders who own the corporations, these distribu- Equity versus debt finance tions are also included in the shareholders’ taxable Double taxation also makes equity finance “more income. costly” to the corporation than debt finance. This is The consequence of this system is that the re- because corporations are allowed to deduct interest turn on equity investments in corporate activities is payments on corporate taxes as a business expense taxed twice. For example, if the statutory corporate but are not allowed to take a tax deduction for the tax rate is 34 percent and the personal tax rate is costs of equity finance. As a consequence, the re- 33 percent, one dollar of corporate earnings is first turns from corporate investments that are ultimately reduced by 34 cents in corporate profits taxes, which paid out to bondholders are subject to only one level leaves the corporation with 66 cents that can either of tax. In effect, this means that one dollar of in- be kept as retained earnings or paid out in dividends. vestment that is financed by debt needs to earn a If the 66 cents is paid out in dividends, this amount lower overall rate of return in order to pay bond- would be included in a shareholders’ taxable income holders their required return after tax, because this and would be subject to the personal tax of 33 per- dollar is subject only to the personal income tax, cent, leaving the shareholder with 44 cents. This than does one dollar of investment that is financed situation may be contrasted with a dollar that is by equity, which is subject to both the corporate and earned by, for example, a business that is not incor- personal income taxes. porated. In that case one dollar of earnings would be subject only to the personal income tax, and the Policy implications owners of the unincorporated business would get to Double taxation of corporate equity has given rise to keep 66 cents. calls for integrating the corporate and personal in- Double taxation of corporate earnings has long come taxes. This is discussed in more detail in the been considered a nettlesome problem of the U.S. entry Integration, corporate tax. The tax system also tax system, and it is believed to affect business has features that are designed to attenuate the effects behavior in several ways. One that has received par- of double taxation, including the tax treatment given ticular attention is the corporation’s decision as to Subchapter S corporations. to how much of its after-tax earnings to retain and how much to pay out to shareholders in dividends. Cross references: dividends-received deduction; Another is the corporation’s decision about how to income tax, corporate, federal; income tax, federal; finance its investments. integration, corporate tax; Subchapter S corporation..
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