Tuesday, October 05, 2010

Taxing dividends is illogical and wrong

In the course of the debates over tax rates a point which those advocating higher taxes for the rich often make is that the average tax rate paid by the rich is lower than that paid by less wealthy high income earners. These claims are nonsense at best and disingenuous untruths at worst.

Taxing dividends is double taxation

Here's why:

1. in simple terms, a company is a pooling of the investments of its shareholders. Apart from some legal distinctions which are not relevant, it is little different from a partnership for present purposes (although the tax treatment is vastly different). If the company makes a profit, it does so with the shareholders' money and does so for the shareholders;

2. if a company makes a profit, it will pay tax on that profit;

3. the company may decide to hand some or all of the tax paid profits over to its shareholders by way of a dividend - the critical point is that what is given to shareholders already represents the profits which have been earned using the shareholders' money and on which tax has already been paid. No additional economic activity takes place and no additional income or profit is earned by anyone;

4. this means that tax has already been paid on the profits before they are distributed to shareholders. Taxing those distributions again is double taxation - taxing the same income twice. This is plainly wrong.

Some countries have recognised the issue

Some countries recognise that taxing dividends as income is a form of double taxation and have addressed the issue. Australia and New Zealand have an imputation regime under which dividends are deemed to be net of the amount of tax which the company has already paid on the underlying earnings. The main effect of these regimes is to capture the differences between the company's tax rate and the marginal tax rate of the recipients of the dividends and avoid the penalty effect of double taxation. Hong Kong goes further and mostly ignores dividends for tax purposes.

Inconsistent to treat partnerships and companies differently

Further support for treating dividends as income and double taxing them can be found by comparing the treatment of income earned from investing in a partnership (no double taxation) and a company (which is subject to double taxation). Differences in the form of legal vehicle should have no material bearing on the amount of tax to be paid.

Contradiction in double tax regimes

The final point to be made on this issue is the contradiction of treating dividends as taxable income in the hands of the recipient but not as a tax deductible expense on the part of the company. As a general principle, what is assessable revenue for a recipient should be a deductible expense for the payer.

Arguing from a false premise

Assertions that those who receive dividends (and capital gains) do not pay a "fair" share of taxes, fail to recognise the fact that tax has not only been paid on the underlying earnings already but is being paid again when the dividend is treated as taxable income. The net result is that the actual tax rates being paid on the relevant earnings are actually significantly higher than is claimed.

Consequences

History has shown that this double tax issue has consequences - companies are less likely to pay, and shareholders are less likely to want, dividends if the effect of the dividend is to transfer some of the tax paid profits of the company to the tax collectors without any actual income being generated. It is little wonder that dividend yields are so much higher in countries (like Australia) which treat dividends appropriately, than in countries which impose punitive double tax regimes. It is also at least a partial explanation for the massive amounts of unproductive cash sitting on the books of many companies. While I am not an expert in assessing the cost of capital to a company, it seems fairly reasonable to also expect that a double tax regime increases the cost of capital to the company with the usual consequences following.

And capital gains?

The same principle also applies to taxation of capital gains (although other factors involved make the analysis more complicated).

2 comments:

Chong Kong Hui said...

Which country has this outdated taxing system?

Malaysia already implement a simple a clean tax system on dividend two years ago. No double tax, no refund is required.

traineeinvestor said...

Thanks for dropping by.

Many countries still have the draonian double tax system - the USA being the prime offender.

Hopefully more countries will see the injustice in such practices but I am not optimistic.