Simple Cures for What Ails corporations.(COMMENTARY)

The Washington Times (Washington, DC), September 26, 2002 | Go to article overview

Simple Cures for What Ails corporations.(COMMENTARY)


Byline: William A. Niskanen, SPECIAL TO THE WASHINGTON TIMES

Enron, WorldCom, and company failed by making unusually bad business decisions - not by violating accounting standards.

Almost all the public debate about the failure of those large corporations, however, has focused on how to improve accounting standards and auditing procedures while ignoring how current government policies increase the frequency and magnitude of corporate failures. Without changing the policies that contribute to corporate failures, the primary effect of improved accounting rules and auditing procedures would be to speed bankruptcies.

Corporations go bankrupt when they can no longer meet the obligations to their creditors. This is a result of some combination of unusually risky investments and unduly high debt.

Bankruptcy is the limiting step in the process of reallocating capital, and the optimal number of bankruptcies is not zero. Current government policies, however, lead to a larger-than-optimal rate of bankruptcy.

The federal tax code is the major policy that increases the conditions that lead to corporate bankruptcy. First, the corporate earnings subject to taxation exclude interest payments but not dividends. This leads corporations to use more debt than would be the case if the tax treatment of interest and dividends were the same. The combined federal and state corporate income tax rate in the United States is now the fourth-highest among the industrial nations, so one should expect American corporations to be unduly dependent on debt finance.

Second, for most investors, the tax rate on dividend income is much higher than the rate on long-term capital gains. This leads corporations to rely more on capital gains than on dividends as the return to equity. This bias also leads to several other adverse effects - reducing the cash-flow discipline to meet dividend payments, increasing the incentive to inflate the stock price, and increasing the role of corporate managers relative to investors in the allocation of capital.

The simplest way to reduce these two tax-related problems is to allow corporations to deduct half of their dividend payments from the earnings subject to the corporate income tax. This would make the combined corporate and personal tax rate on interest and dividends about the same for most investors without changing any other feature of the corporate or personal income tax code and would roughly eliminate those adverse conditions attributable to the current difference in those rates. …

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