Dividend Taxation and Corporate Governance

T he U.S. government subjects corporate dividends to double taxation: It first taxes corporate income, then taxes the same income again when shareholders receive dividends paid out of corporate income. Until 2003, individuals were taxed on dividend income at the same rates as on other forms of income, resulting in overall taxes on dividends much higher than those in most other countries (PriceWaterhouse-Coopers, 2003a, b). After the passage of the Job Growth and Taxpayer Relief Reconciliation Act of 2003, dividends are still paid out of after-tax corporate income, but the individual tax rate on dividend income was cut to a maximum of 15 percent. We argue that this act, by substantially reducing double taxation of dividends but not eliminating such taxation, strikes a useful balance between competing objectives. Many economists have long opposed the double taxation of dividends because of the high overall tax rates this imposed on corporate income. They argued that double taxation deterred corporate investment and distorted corporate financing decisions, favoring debt over equity financing and earnings retention over dividend payouts. More recently, financial economists stressed how higher dividends (and consequently reduced retained earnings) can improve corporate governance by discouraging empire-building financed by retained earnings.