But taxes do have a considerable impact on the way even individuals do things. For example, over half of the money I have saved is with an asset management company, called "American Funds". Not because I like them; in fact, I don't. The funds that I have to choose from have higher costs than I'd like, they're actively managed and I'd rather buy an index fund, and many of their biggest holdings are with companies that I hate. Or they have investing strategies that I dislike. I'm not happy with them.
Oh, they’re not horrible, as far as I can tell, but they’re far from my ideal. I’d much rather have all my investments in Vanguard's funds; I particularly like their index funds.
So why do I have all this money with American Funds and not Vanguard? Because the company that administers my 401k only offers us American Funds (and only ten of their products, for that matter.)
And the tax advantages of investing through a 401K are huge. When money’s put into a 401k, it’s tax-deductible, and it grows tax-deferred. The employer-match I get from Toddler Bank is negligible compared to the advantages of having money grow tax-deferred. But I went over all that in this enty, so I won’t do that again.
Another common way that taxes distort behavior is the home mortgage interest deduction. This gives a tax incentive to have a long-term mortgage on your own home. It encourages people to stay heavily leveraged in their homes, because it’s more tax-efficient to use the money that might pay off that loan for another investment. (“Hmm, I can use this $100,000 to pay off my home mortgage, and lose my $5,000 a year tax deduction, or I can buy stock with my $100,000 and continue to make loan payments and get the tax deduction.”)
Let me get to the point: corporate behavior. Corporations have the same interest in lower taxes that individuals do, but the key difference is that corporations have lots more income to protect than most of us. And they have professional accountants out there to try to protect it. On the balance sheet of a corporation, income tax is just another expense, and worse, it’s an expense that they gain nothing by paying. They have a fiduciary obligation to their stockholders to reduce this expense in any legal fashion they can.
And there are many legal ways for a corporation to reduce taxes.
The result: corporations do all kinds of ridiculous, and often costly, things, for no reason other than it’s the most tax-efficient way to do it. Things which would be absurd in a world without taxes become brilliant planning in corporate America.
One of the ways that tax law has come to distort corporate behavior is through dividends.
A corporation pays taxes on its profits, much the same way individuals pay taxes on their income. Corporations can do a number of things with their profits.
--Reinvest it in their business. Open new locations, hire more employees to expand their organization, etc.
--Invest it by buying a new business. Doesn’t even have to be a related business. This is how cigarette companies end up owning furniture stores.
--Invest it in stocks or bonds, just the same way an individual would
--Invest it in their own stock (stock buybacks). Buying shares of your own stock may seem strange, but, at least in the short term, it increases the value of your stock (lowered supply = higher prices) and reduces share dilution. (Fewer shares in circulation means each stock holder now owns a higher percentage of the corporation.)
--Give it back to the stock holders in the form of dividends.
In a world without taxes, all of these could make sense under differing circumstances. And all of them would be mind-bogglingly stupid under other circumstances. If a company has no profits, handing out dividends is suicidal if not fraudulent. If your stock is trading at 100 times p/e, buying more of it suggests a level of hubris bordering on the insane.
And, generally speaking, in a world without taxes, it doesn’t make a lot of sense for the average non-holding company to be investing in the broader market. If a corporation has a pile of cash, it’d make more sense to distribute that cash to its owners, and let them decide what they want to do with it, rather than arbitrarily putting it into tech stocks or treasury bonds or whathaveyou. Unless the corporation is an investment business, there’s no reason to believe it has greater expertise available than its owners do. So let the owners spend or invest the money, as they choose.
But we do not live in a world without taxes. And in America today, one of the options above is heavily penalized by taxes: granting dividends.
A corporation has to swim against the tide, almost be moronic, to give out dividends in the current tax climate. Stockholders hate dividends, because they’re taxed as soon as they’re given out. They’d rather see the value of the stock rise, which won’t incur taxes unless the stock is sold, than see a dividend.
Because the general climate is so strongly opposed to dividends (“what kind of company would be so dumb as to let me spend my own money? I don’t want to buy that stock!”) even people who depend on being able to spend investment income (eg, retirees) don’t depend on dividends. It’s so hard to find a stock that offers meaningful dividends that it’s not worth the trouble. Easier to invest in bonds (which get favorable tax treatment – a company can take interest paid on loans as a tax deduction.)
The “dividends are bad mentality has another interesting side effect: fraud becomes much easier. Faking dividends, which involves taking real money and giving it to real people, is hard. But faking earnings? Or profits that you don’t need to give out? That’s dead easy. Just look at Enron, or WorldCom. Book income today that you haven’t received yet, or may never get? Sure! No one expects you to do anything tangible with the income anyway. They’ll never know it wasn’t real!
This is why I favor an end to the taxation of dividends. Hey, I’ll admit it, I’m a libertarian, and lowering taxes is just generally a Good Thing. But taxes on dividends are one of the especially pernicious ones. It’s not just that they take money from people: it’s that they distort corporate behavior in a profoundly negative fashion. An otherwise intelligent, rational choice has been rendered ridiculous by the way dividends are taxed.