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The cost of double taxation

  If the company chooses to pay out the earnings as a dividend, the shareholder gets a check for 60, the earnings that remain after corporate income tax. The dividend check being taxable income, the shareholder must pay 24 (40% of 60) of tax on the dividend, leaving 36 of the original dollar earned by the company. Although these numbers will vary depending upon the tax rates paid by the company and the investor, it's clear that with taxes taking 64% of every dollar, operating a company in order to pay revenues out as dividends is a far more effective way of transferring wealth to the government, which ends up with 64 from each dollar, than to the shareholder, who's left with 36.

Viewed in this light, even to contemplate paying dividends may seem the purest lunacy. There are, however, a few more facts to consider. If a business can neither spend its earnings productively (or must generate after-tax earnings to satisfy market expectations), nor has a need for debt which would transfer before-tax earnings to bondholders, payment of corporate income tax is unavoidable. Once the earnings have been booked only two alternatives remain: add them to the company's working capital pool or pay them out. Once the company has amassed working capital adequate for its needs, the shareholders begin to become restive. They demand, and rightfully so, ``If you can't think of anything to do with the money other than buy Treasury Bills, why don't you give it back and let us decide how to invest it?''. After all, once earnings are reported, payment of corporate income tax is a foregone conclusion. The shareholder does not look at the fraction of pre-tax earnings retained; he sees the after-tax earnings per share reported by the company, multiplies that by his holdings, and begins to think how nice it would be to find a check for that sum in his mailbox, notwithstanding the need to pay taxes on it.


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Editor: John Walker