Academic journal article Atlantic Economic Journal

The Triple Taxation of Corporate Equity Profits

Academic journal article Atlantic Economic Journal

The Triple Taxation of Corporate Equity Profits

Article excerpt


Corporate (1) equity is the major form of commercial investment in the United States. Taxes on corporate equity impact the incentives to invest, which, in turn, impact economic growth. The economic analysis of public finance, therefore, is dependent upon an accurate understanding of the aggregate impact of the three taxes on corporate equity profits: the corporate income tax, the dividend income tax, and the capital gains tax. This paper attempts to further that understanding by showing how this aggregate impact can be quantified under a triple taxation model.

It is commonly recognized that dividends are distributed corporate income, thus justifying the assertion that dividends are double taxed by the corporate income and the dividend income taxes. It is less often observed that capital gains reflect the value created by reinvested corporate earnings, which also results in a double-taxation due to the combined impact of corporate income and capital gains taxes. If it is further recognized that capital gains reflect expected dividend growth based on rising profits from reinvested earnings, then it becomes clear that all three of these taxes (on corporate income, dividends, and capital gains) apply to the same corporate equity profits. Hence, these profits are subject to triple taxation.

Although it is often assumed that dividends and capital gains are two independent sources of equity income (for example, see Zodrow, 1991), the idea that capital gains reflect future corporate payments to investors is not new. Ray Ball [1984] explains how capital gains taxes duplicate the taxation of the future investment income that is the basis of an investment asset's value. Ball concludes that a capital gains tax can be justified only as a backstop to insure that this income does not escape taxation due to tax avoidance devices. Collins and Kemsley [2000] analyze stock prices and changes in Federal dividend and capital gain tax rates from 1975 through 1997. They find their data "consistent with the hypothesis that capital gains taxes represent a third layer of taxes that investors incur in addition to corporate and full dividend taxes," where all three reduce the value of reinvested earnings (p. 407).

Burton Malkiel, in his popular book, A Random Walk Down Wall Street [1990], refers to the idea that equity values are equal to the present value of all future dividends as the 'firm-foundation theory' of 'intrinsic value.' Malkiel (p. 29) concludes, "The logic of the firm-foundation theory is quite respectable and can be illustrated best with common stocks. The theory stresses that a stock's value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends." Clearly, if equity values are the present value of all future dividends, then capital gains must reflect changes in that present value from one period to another.

This paper adopts the view that the corporate, dividend, and capital gains taxes do constitute a triple tax on equity returns. Given this premise, the paper intends to show how the aggregate impact of this triple taxation can be calculated in relation to the net present value of a prospective equity investment. Although the paper does not attempt to settle the debate on the relationship between future dividends and capital gains, it furthers that debate by quantifying the implications of the triple tax point of view. The algorithms developed here allow the reader to consider the mathematical logic of the triple tax perspective, and provide a basis for developing its tax-policy implications.

The paper begins with the conceptual argument that corporate equity is triple taxed, as background to the subsequent analysis. This is followed by a development of algorithms for computing the net present value of equity investments subject to the triple taxation of corporate income, dividend income, and capital gains. …

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