Obama doesn’t understand Corporate Tax

Posted in Uncategorized by a1icey on February 20, 2012

Obama had my vote in November but after he released his budget, I am less sure. His budget maintains capital gain rates but increases dividend rates back up to ordinary income levels. He could have increased both, but kept them the same. This tax policy decision was beyond retarded – it exhibits cowardice, a very short memory, and a lack of conceptual sophistication on his administration’s part.

About ten years ago, they stopped taxing dividends at the rate of ordinary income and started taxing them like capital gain. For 80 years, trying to avoid dividend tax was the primary drive of corporate financing decisions, business form choices, and controlled many areas of tax and accounting. But CAPITAL GAIN AND DIVIDENDS ARE THE SAME. We made a mistake when we first created the modern corporation. We made a massive mistake in distinguishing between the two for tax purposes. We made a really good choice when we removed that distinction ten years ago. Tax law should never control business decisions.

Interestingly this same shift in perception had already occurred in the area of trusts and estate planning. A notoriously archaic area fixed this problem before our tax system did.

To explain why dividends need to be treated the same as capital gain, it’s best for me to explain the logic of the unitrust.

First: dividends are payments out of the current and accumulated profits of a corporation, based on the number of shares you hold. Capital gain is the increase in value of the corporation, based on the number of shares of the corporation you hold. A corporation can pay out profits as dividends, or they can hold on to them increasing the value of the corporation. Some rules require the corporation to pay dividends, but generally shareholders can dictate whether or not this happens. Really their net benefit is the same either way, aside from the fact that for capital gain some shares must be sold.

Trusts are written to last fifty years. Various estate tax rules and planning needs lead to standard ways to structure a trust. Typically, the income is paid to one person and the principal is paid out at the end of the life of the trust. Income was defined by state governments according to how it was perceived at the time these trusts became popular: rental income on property, interest on bonds (loans), and dividends paid on shares. Principal was the property, bond, or share held by the trust. But money is invested differently now and for mostly tax reasons, dividends are rarely paid. Investments make money through capital gain, purchasing low and selling high.

The unitrust is simply a redefinition of income. Any existing trust, written without anticipating the changes in investment behavior, could only pay out whatever paltry sum came through as dividends or bond interest. People were supposed to live off of this money and couldn’t-the trust sat around basically useless until it ended. Income under unitrust statutes is simplified to 4% of what the trust owns – an assumed rate of growth for a conservative portfolio over the course of several decades. Thus the trustee is authorized to sell some shares to pay income to the person benefiting from the trust.

Unitrusts essentially accept that capital gain and dividends are the same, they are the result of choosing to invest in strong companies. This problem is made worse for high tech investors. Tech companies have such massive R&D costs that they generally have to reinvest all profits into R&D (until they reach the level of stability of Microsoft). Dividends are not just uncommon because of decades of punitive tax. They’re going out of style.

However, dividends were designed to provide a useful purpose. Arguably, leaving stockpiles of cash in the hands of a corporation is not an effective distribution of economic power. Arguably, shares held for dividend payments are held longer and the shareholder will take a more active interest in the company. Arguably, encouraging dividend payouts may help to combat short-termism which is harmful to our culture and economy.

Increasing dividend tax without increasing capital gain is just going to punish less-informed or conservative investors (retired people, small business owners) over people making more risky investments. However we all know Goldman Sachs was the top contributor to Obama’s 2008 campaign. Since in a lot of ways, dividend or capital gain is a choice that a company can make in distributing profits, maintaining capital gain rates just ensures companies advised by Goldman can help shareholders avoid the higher tax, while others less fortunate or well-advised cannot.



One Response

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