DOUBLE TAXATION OF DIVIDENDS (2024)

DOUBLETAXATION OF DIVIDENDS: A CLARIFICATION

byConfidence W. Amadi

INTRODUCTION

The corporate form of businessorganization is the most successful form of businessina capitalistic economy because, although it accountsfor less than 20 percent of the total number of businesses, it generates more than90 percent sales and 70 percent of total profits.The success of the corporate form of business lies in the separation ofthe corporation from its ownership and the resulting limited liability towhich its owners are exposed.Despite its success,the corporate form has been criticized on several grounds, including the difficultyin formation and the agency conflict resulting from the separation of ownershipand control.The most important criticism is the double taxation of dividend income accruing toshareholders. [See Van Horne and Wachowicz Jr, 2001, 13-16 and Gallagher andAndrew, Jr, 2000, 13-14 .] The costof formation can be written off as a cost of doing business. While the agencyconflict has received a lot of attention in the literature [See Megginson,1996:314-336.], the validity of the double taxation argument has, to the best of myknowledge, been ignored or taken for granted.The objective of this paper is to address the apparent misconception ofthe taxation of dividends and to show that the “double taxation ofdividends” is an example of the economic cliché “there is no free lunch.”

THE CORPORATION, PUBLIC GOODS, AND TAXES

Thecorporation is a “legal entity” that is created by law in each of thestates.It can own property. Itcan sue and be sued. It can enterinto contracts. Its officers are considered agents of the corporation.Its existence is separate from, and independent of, its owners.The courts have also upheld the corporation’s “right to due processand equal protection of the laws under the Fifth and FourteenthAmendments.” [Gowri, 1998] Gowri(1998), also presents an argument regarding the corporation’s right of freespeech and political expression under the First Amendment.

Oneof the failures of the private sector is its inability to provide public goodsefficiently. This is becausepublic goods have almost zero marginal cost.The cost of one more user of a public good, up to a point, is virtuallyzero. Moreover, a public good hasthe additional characteristic of non-excludability.This characteristic makes it impossible or impractical to prevent thosewho do not pay for the good from enjoying the benefits.Consequently, public good has to be collectively provided by thegovernment.

Ina free market economy, the government does not own the factors of production.It must rely on the private sector to produce publicgoods, while relying on tax revenues to pay for the cost of these goods.Schuman and OlufsIII (1993, 414-420), discuss several principles that canguide the choice of who should pay taxes.Theseprinciples range from benefits received from government services, ability to payas measured by their income, to the concept of tax policies that changepeople'seconomic behavior (“sin” taxes).Corporations, as beneficiaries of public goods, are, therefore, required topay for the services the government provides.

In the 1980’s, as noted in Schuman and Olfs,President Reaganargued that corporations do not pay taxes; rather, they pass them along toconsumers in the form of higher prices. The Reagan administration’s taxproposal would have abolished corporate taxes had a majority of the lawmakers orcitizens accepted their argument.Thepopular view, as suggested by Schuman and Olufs III, “is that they are rich,powerful, and privileged forces in the economy. To absolve corporations of taxeswould seriously undermine citizen confidence in the fairness of government.”Thus, in the interest of fairness, corporations have to pay taxes.

THECORPORATIONAND ITS SHAREHOLDERS

Oneof the primary benefits of the corporate form of business organization is theseparation of the owners from the corporation.Shareholders benefit from the public goods provided by thegovernment.They pay taxes so thatthe government can purchase these goods from their producers.Corporations enjoy the same benefits.The fact that shareholders enjoy the benefits provided by public goods inno way detracts from the corporation’s ability to enjoy the same benefits.Shareholders pay their share of the cost of public goods.Corporation, aslegal entities, also need to pay their share of the cost of the public goodsthey consume.Therefore, thecorporation and its shareholders are two separate economic units.

Thenotion of the double taxation of dividends is predicated on the assumption that it isincome that is being taxed.Economicunits pay taxes based on their income. Firms, under the corporate form ofbusiness organization, are economic units created by the states, with all the“rights and privileges”.Likeindividuals, theyalso have income.

Based on the ability-to-pay-concept, income serves as a means of determining the tax liability ofeach economic unit. In allocating acorporation’s costs that cannot easily be identified with a specificproduct, Generally Accepted Accounting Principles (GAAP) requires that in costing forgoods or services, such costs can be allocated based on such factors as directlabor hours or costs, and/or direct material usage.This is the same concept being applied to the allocation of the cost ofpublic goods. In this case incomeis used as the basis for allocation.

Quiggin(1998)has shown that in the presence of “non-paternalistic altruism towards familymembers, the sum of private willingness to pay for public goods will equalhousehold willingness to pay which is less than the sum of individualwillingness to pay.”This impliesthat the estimate of the aggregate benefit from public goods will be greaterthan the willingness to pay of the households as a whole when individualwillingness to pay is used as a basis for benefit estimation.Quiqqin’s findings help explain the rejection of the ReaganAdministration’s argument for eliminating corporate income tax. In the contextof shareholders and corporations, the shareholders and the corporation can beconstrued as members of the same household, with the concern about taxation ofcorporate income a consequence of the household's willingness to pay being lessthan the benefits accruing to individual household members.Since both the corporation and the shareholders benefit from publicgoods, the elimination of the corporate income tax would reduce the tax burdenon the household without reducing benefits.

CORPORATETAXES AS A BENEFIT TO SHAREHOLDERS

Thegovernment has more than one avenue through which it can collect the enoughrevenue to cover the cost of public goods.SeveralEuropean nations use a form of consumption-based tax or value added tax.The effect of these taxes on the price paid by consumers for privategoods and services is similar to the effect of the corporate income tax system.The profitability of a capital project is based on its after tax cashflow.The corporate tax is treatedas a cost of doing business and factored into the price the consumers pay forthe goods and services.

TheUnited State could adopt the European tax system, however, as Schuman and OlufsIII (1993, 421-422), point out, “ a major problem with consumption taxes isthey tend to be regressive.Poorerpeople consume all of their income.”Thisline of reasoning attempts to portray a consumption-based tax system as an attack andundue burden on the less fortunate members of society.Theargument of Schuman and Olufs applies equally to the corporate income taxsystem because the price poorer people payfor the goods and services they consume already has the corporate income taxfactored into it.This negates theregressive argument against consumption taxes.There is a much more potent reason for the perceived preference ofcorporate income taxes over consumption taxes.Corporate income taxes are paid only when the firm’s revenues for theperiod exceeds its explicit expenses, despite the fact that the price the firmreceives on each unit of product sold includes a tax mark-up. On the other hand,consumption taxes are based on each unit sold.Retailers merely act as tax collectors for the government.Moreover, the practice in which corporations are allowed to carry theirlosses backwards and forwards to offset past and future tax liabilitystrengthens this preference for the corporate income tax.

Considerthe hypothetical pro forma income statement presented in Table1 (below). Column 2 shows the income statement in dollars, and column 3 is acommon size version of the income statement with every account expressed on aper dollar of sales basis.Column 4is the income statement on a per unit of product basis, with an assumed unitprice of $250.00.Column 5and 6 depict income statement under a 20 percent change in sales volume (in units ofproduct) in either direction.

Basedon the sales of 28,448 units, the income tax per unit of product sales is $6.90or 2.76 percent of sales.Under asimplified consumption tax system, this will be the amount of tax assessed onthe consumer for the purchase of the product. The price of the product beforeconsumption tax will be $243.10. Whensales decline by 20 percent to 22,752 units, the tax collected by the retailer for thegovernment will be $156, 989.00 under a consumption type tax system.In the case of the corporate income tax system, the tax liability is$65,287.The difference of$91,702.00, which was already collected through the higher price of $250.00,goes to subsidize the shareholders for the uncertainty in the forecasting of sales,since a payment of the consumption tax will leave the firm with a net income ofjust $6,229.00, a 97.88 percent reduction in forecast earning. With a 20 percentincrease insales, the tax liability under consumption tax will be $235,552.00, while thecorporate tax liability is $327,165.00, a difference of$91,613.00. The use of consumption tax will leave the firm with a netincome of $582,361.00, a 97.78percent increase in earnings.

The degree of combined leverage in a consumption taxenvironment is 4.89, compared to 3.33 for the corporate income tax environment.Ross, Westerfield and Jordan (2003: 368) note that the higher the degree ofoperating leverage, the greater is the potential danger from forecasting risk.Since the degree of combined leverage measures the combined effect ofoperating (a business) and financial risk due to leverage, the use of corporatetax as opposed to consumption tax resulted in a 46.69 percent reduction in the impactof forecasting risk.Thus, thecorporate tax system reduces the variability in a firm’s earnings, henceserving to reduce the overall risk of the business. Forecasting risk impacts all firms, with the magnitudedependent on the firm’s use of fixed production costs. As a result, thiseffect of the corporate income tax system benefits all for profit-seeking organizations.

Another benefit that the corporateincome tax system confers on shareholders is the loss carry backward and carryforward concept. This practiceallows the corporation to recoup all the taxes it paid on taxable past andfuture income equal in magnitude to its losses. The net effect of this conceptis to make the corporation a free rider on public goods in years when it has anegative income as well as prior and future years until its taxable incomeequals its loss.

The argument that describes the tax on corporate income as double taxation indirectlyassumes that it reduces the benefits that could accrue to shareholders. In adiscussion on the impact of tax differentials on business location, Netzer(1997) reports on the findings that “in a competitive environment forboth residents and businesses, the taxes they pay will exactly equal the valuethey place on the public services they receive.”Moreover, he argues, that even though businesses pay wages equal to themarginal product of labor, they benefit additionally from the funds localcommunities spend on education.Inthe absence of an educated work force, a business can be forced to relocate.Relocation is costly.Yet,with these benefits, local communities offer huge tax incentives to attractbusinesses.According to Downs (1997), businesses are being subsidizedfor what they will normally do.Thisis a loss to the society and a benefit to the firm’s shareholders.If a firm “picks a location that is not the best location, then itchooses a site that is economically inefficient.” This will lead to theproduction of fewer private goods as well as fewer public goods as a result ofthe subsidy tax dollars diverted from the production of public goods.On the other hand, if a firm is subsidized in order to induce it to choose a site, it willnormally have chosen it on the basis of its own merit; therefore, the business is being subsidized at theexpense of public goods. Thisbenefit will flow through to the shareholders.

Thegreatest advantage of the corporate form of business organization is the limitedliability protection accorded its owners. Taxation of corporate income is theprice of that protection. hisprice must be worth the benefits since, according to the Internal RevenueService (1996), corporations account for less than 20 percent of all U.S.business firms, but about 90 percent of U.S. business revenues and approximately70 percent of U.S. business profits.Thebenefits of limited liability independent of those enjoyed by shareholders, the flexibility of change in ownership, and the immense ability to raisecapital areall derived from the legal entity status accorded corporations by the law. Thisequal status requires that corporations pay income taxes.

CONCLUSION

The“double taxation” of dividends is often cited as one of the disadvantagesof the corporate form of business organization.This paperhas attempted to dismiss this criticism and show that theseparation of the shareholders from the corporation is a sufficient ground forcorporations to pay taxes as consumers of public goods.Moreover, the concept of double taxation assumes that it isincomethat is taxed. Economic units paytaxes.Income is merely aconvenient means of allocating the cost of public goods to the economic unitsthat consume the public goods.Inaddition, this paper has shown that eliminating corporate tax in favor ofconsumption tax will increase the riskiness (variability) of a firm’s earningsthrough the increase in the difficulty encountered in forecasting risk. It could also eliminate thesubsidies that accrue to shareholders because of the existence of the corporatetax. Finally, in all aspects of theactivities of the corporation it is considered independent of its shareholders,and double taxation is an integral part of this separation.

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