Table of Contents
Criticisms of taxes imposed on investors’ receipt of dividend payments and capital gains have been long debated in both political and academic spheres. The primary issue taken with taxes on dividend payments is the double taxation that occurs, in that corporate profits are taxed to reach net income, which are then taxed a second time as income to the company’s shareholders. The taxation of dividends also has numerous unintended effects on investors, as well as financial markets in their entirety. Similarly, capital gains tax laws have been argued to lower returns for all investors, as they can act as an incentive for an investor to sell positions with a market value below their cost basis at year-end. These issues are explored further in this article.
Dividends
The decision to tax dividend payments to shareholders comes with several potential negative outcomes, such as deterring corporate investment, distorting corporate financing decisions, and favoring increased leverage over equity financing and earnings retention over dividend payouts (Morck, Yeung 163). The taxation of dividends increases a company’s cost of equity financing and depresses share prices, which is implied by the value of a company’s shares, on the ex-dividend date, falling by the after-tax value of the dividend yield (Morck, Yeung 167). With share prices depressed, companies are further incentivized to rely on debt financing, and benefit from tax deductible interest payments. This raises concerns of an increase in the credit risk of companies, which is avoidable if taxes on the receipt of dividends were removed.
It is also argued that the taxation of dividends violates horizontal equity, which holds that taxpayers with the same income should pay the same in taxes in any given year, acting as a gauge of whether tax burdens are distributed equally. In this sense, the taxation of dividends is unfair because “a shareholder that is taxed on a dividend out of earnings that have already been taxed at the corporate level is bearing a heavier tax burden than an individual in the same tax bracket receiving equivalent income” (Peel, 2). It would be in the shareholder’s best interest to receive no dividend from the corporation, and instead sell their shares (if the market cap reflects the company’s accumulated earnings) to be taxed at the substantially lower long-term capital gains rate (Peel, 3).
Because of the tax advantages of long-term capital gains, companies have turned to share repurchases as the preferred method of returning capital to shareholders. According to Fama and French (2001), this has also been driven by changing firm characteristics and a declining propensity to pay. There are more publicly traded firms today that cannot pay dividends, as they have yet to achieve profitability, have higher growth expectations, and a greater percentage of intangible assets relative to total assets. US industrial firms, for example, are characterized by stability of earnings and the ability to pay regular dividends. In the 1950’s, 80% of industrial firms paid dividends, which fell to 67% in 1978, and to 20% in 1999 (Eije, Megginson 349). The declining propensity to pay includes tax effects of dividend payments and the changing preferences of investors.
This may also contribute to an increase in the riskiness of firms as dividend payments require companies to hold onto retained earnings until the date of payment, whereas share repurchases can be done through continuous purchasing on the open market. Cash needed for unforeseen circumstances may be unavailable to firms who have already spent it on their own shares, whereas a dividend-paying company can suspend the next quarter’s dividend if that cash is needed elsewhere.
The taxation of dividends may also have an indirect effect on a company’s corporate governance, as it deters equity investment from taxable individual investors and incentivizes investment from tax-exempt institutional investors like pension funds. This leads to financial institutions maintaining disproportionate influence on corporations, further deterring individual investors from owning dividend-paying companies due to their lack of influence on decisions of companies they own (Morck, Yeung 173).
Capital Gains
Short-term capital gains are investments purchased and then sold within one year and are taxed as ordinary income to investors. Long-term capital gains are investments purchased and held for longer than one year and are taxed at rates dependent on a taxpayer’s taxable income. For the 2023 tax year, individuals do not pay long-term capital gains tax if their taxable income is less than $44,625, with the rate increasing to fifteen percent for income in the range of $44,626 to $492,300, and to twenty percent beyond this upper limit (bankrate.com). The taxation of capital gains incentivizes investors to realize losses on positions that have declined below their cost basis to offset gains realized on positions that have appreciated above their cost basis. It has been argued that this incentive results in unusual stock returns at the end of each calendar year.
For example, if an investor has held an asset for more than one year, selling that asset before the end of the calendar year allows them to deduct that loss against realized gains to reduce their tax liability in that year. This may be the optimal decision, rather than holding the asset, hoping that its price recovers in the next year (which is not guaranteed), and not being able to deduct the loss until the following year, increasing this year’s tax liability.
There is empirical evidence that supports the hypothesis that tax-loss selling impacts stock index performance. Prior to 1976, investments qualified as long-term if held for more than six months. This meant that investors were incentivized to sell investments that accrue losses in the first half of the year before year-end. It has been observed that the relationship between January-June losses and turn-of-the-year returns is weaker than when the required holding period for an investment to qualify as long-term is twelve months. This suggests that “changes in tax rules are linked to turn-of-the-year returns, and it therefore supports the role of tax-induced trading in contributing to turn-of-the-year return anomalies” (Poterba, Weisbenner 362). Investors who are aware of this phenomenon may benefit from purchasing shares of companies that have underperformed during the year at year-end (lowering index returns), with the expectation that the security’s price will recover after tax-loss sales have been realized.
Conclusion
It is clear through just these two taxes imposed on investors that tax policy can lead to numerous negative consequences throughout the financial markets and overall economy. Tax policies can also incentivize certain behaviors from investors that may not have been intended by the legislation. Because of this, governments should be sure to thoroughly examine potential outcomes of tax policies beyond their original intention and react quickly when these outcomes are seen to be detrimental to those affected by it.
Further Reading
https://pubs.aeaweb.org/doi/pdfplus/10.1257/089533005774357752
https://heinonline.org/HOL/Page?handle=hein.journals/txlr39&id=1&collection=journals&index=.
