Elimination of the Double Taxation of Dividends and Corporate Financial Policy

Abstract

IN RECENT YEARS, there has been a great deal of discussion about eliminating the double taxation of dividends. Tax reform proposals for eliminating double taxation were proposed by the Ford administration and currently are being proposed by the Carter administration. With the present tax system, the investor pays personal income taxes on cash dividends distributed to him and, in addition, his portion of the total earnings of the company is subject to the corporate tax rate. Thus, unlike other sources of income, corporate source income is taxed under two different income taxes-personal and corporate.Many economists propose the integration of corporate and personal income taxes. Full integration would eliminate the corporate income tax altogether with all corporate earnings being taxed at the stockholder level. As a result, a company's earnings, whether retained or distributed, would be taxable to the stockholder on the basis of his proportional ownership of the company. This would occur in the same way that the income of a partnership is taxed to the partners. While a number of economists advocate full integration,' there are many political and practical obstacles which thwart such a radical change.2 Consequently, most of the recent debate has focused on the partial integration of corporate and personal income taxes, one form of which is the elimination of the double taxation of dividends. In some measure, this debate is kept alive by the conspicuousness of the United States in being one of the few advanced industrial countries of the world without some form of partial integration.3 This paper will concentrate on the partial as opposed to the full integration of corporate and personal income taxes. In turn, there are several mechanisms for eliminating the double taxation of dividends. These include deduction of dividends at the corporate level, the stockholder credit method, or some combination of the two.Under the dividend deduction method, the corporation is allowed a tax deduction for dividends in the same way that it is allowed an interest deduction for its debt. Thus, the tax saving is received by the corporation and stockholders continue to * Graduate School of Business, Stanford University. This study was supported by the Stanford Program in Finance, the major contributors to which are the BankAmerica Foundation, General Electric Company, Dean Witter Foundation, Morgan Guaranty Trust Company, Morgan Stanley & Co., and Salomon Brothers. We are grateful to Myron Scholes, James Scott, Howard Sosin, and Mark Wolfson for helpful comments. 1. See, for example, Hollard [10]; McClure [13]; and Feldstein and Frisch [6]. 2. In the mid-1960's, the Carter Commission proposed such a change for Canada and this kindled considerable interest in full integration. However, the proposal was not adopted and has not been adopted in any other country. For an analysis of the Carter Commission plan as it would apply to the United States, see Break [3]. 3. For an excellent review of the integration of corporate and personal taxes i...

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