chased in the belief that the undertaxation of corporate-derived income in the high personal income brackets would continue. A tax reform measure that eliminated both extra taxation and undertaxation would bring bonuses to some and unanticipated losses to others, quite substantial in amount. These facts are arguments, not for refusing to seek a method to eliminate these features, but against hasty action that will have been supplemented or annulled later. Vested interests, innocent or otherwise, cannot be allowed to stand permanently in the way of improving a tax system. But the improvement must be substantial.

7. If overtaxation and undertaxation of dividends are ever to be eliminated in all cases, the formula that does the job will, as indicated above, almost surely be only part of a more general tax reform that will affect taxation of capital gains and undistributed profits. "Dividends," by itself, is too narrow a category to isolate for satisfactory tax reform.

8. Withholding at slightly below the initial bracket rate (now 20 percent) should in any case be applied to dividends. The advantages of this procedure would clearly outweigh, in my opinion, the disadvantages.3

NOTE. The rate of "extra taxation" of corporate income is given by the formula, c(1—m), where c is the rate of corporation income tax, and m is the marginal rate at which the dividends are taxed to the stockholder under the personal income tax. If k is the proportion of dividend that is allowed as a credit against the individual income tax (under the present law, k is 0.04), extra taxation is c(1-m) precisely eliminated when k= (See Shoup, "The Dividend Exclusion 1-c

and Credit in the Revenue Code of 1954," National Tax Journal, p. 147.)

See the proposal by Senator William Proxmire, ibid., pp. 107-113. Senator Proxmire's proposal was defeated in the Senate by a voice vote, June 25, 1959. Wall Street Journal, June 26, 1959.

TAX TREATMENT OF DIVIDENDS

Dan Throop Smith, professor of finance, Harvard Graduate School of Business Administration

Three aspects of the tax treatment of dividends deserve attention in a brief survey of the subject. They are (1) the need for relief of double taxation of income received in the form of corporate dividends, (2) the method of relief, (3) the proper tax treatment of stock dividends in view of new ways of using them by some corporations which declare small annual stock dividends.

The need for relief from double taxation clearly depends on the extent to which there is in fact double taxation, and this in turn depends on the incidence of the corporation income tax. Traditional economic theory has consistently held that a corporate income tax rests on the corporation and is not shifted either forward to consumers or backwards to employees or suppliers. This conclusion is based on a theory which gives critical importance to marginal costs in determining price, and by definition there is no net profit, and hence no income tax element, at the margin. This position has been questioned on both pragmatic and theoretical grounds and a rather extensive literature has developed on the subject. At present there seems to be a fairly widespread uncertainty on the incidence of the corporation income tax, with no very great confidence by anyone on sweeping generalizations or categorical statements that the tax is wholly shifted or wholly borne by the corporation.

It is probable that this uncertainty will continue to exist for some time. The phrase, "It all depends," so frequently used by economists, seems especially appropriate in connection with the possible shifting of the corporation income tax. One can imagine situations in which it is wholly shifted and others where it is not shifted at all. The competitive position in an industry, including the effectiveness of foreign competiton, cyclical and secular factors, and even attitudes on management regarding both the tax and their profit objectives, all influence the actual incidence of the tax. In an aggregate sense, the tax is probably neither entirely shifted nor entirely borne by the corporation, though there are doubtless many instances in which one or the other of these extreme results occur.

A varying incidence of the tax must raise many questions about its proper role in a tax system. To the extent that it is not shifted, relief from double taxation of dividend income is required from the standpoints of both equity and economic policy. To the extent that the tax is shifted, it becomes a most capricious excise tax with possible unintended ramifications. A shifted tax, for example, by forcing prices higher makes more room for less efficient marginal firms to exist. Whether shifted or not, a corporation income tax discriminates against equity financing in the financial planning of individual companies. This result is wholly bad. And, less obviously, the fact of a

tax, even if shifted, increases the return which must be anticipated before tax to secure any required level of net return from an investment of capital funds by business. The raising of the cutoff point for new commitments can be a significant deterrent to economic expansion. Those who support the corporation tax as a revenue source, regardless of its incidence, sometimes ignore these significant consequences of the tax; if, for example, it is shifted some may support it as a hidden and hence painless excise. But an ordinary excise tax does not discriminate against the form of capital which is least available and most important, nor does it influence the cutoff points in allocations of funds in capital budgets. But these are digressions from the main subject of the tax treatment of dividends.

For purposes of this discussion, it is both correct and adequate to say that the corporation income tax does to some extent rest on corporations which pay it. This means that dividends paid to individual stockholders are doubly taxed, both to the corporation and to the individual recipient. Furthermore the double taxation is unique, since all other payments by the corporation to recipients of other forms of income-be they wages, or interest, or royalties are deductible by the corporation and thus taxable only to the final recipient. The issue of fairness is complicated by the fact that the extra tax burden may be reflected in the price of corporate stock by the process referred to as the capitalization of a tax. With a lower net return available because of the tax, stocks will sell at lower prices than they otherwise would to give yields which are competitive with other investments not subject to double taxation. Lower stock prices, though they permit new purchasers of stock to secure reasonable net returns after allowing for the burden of the tax, discourage new stock issues because they make it more likely that new stock will dilute the interests of existing stockholders.

Direct relief for specific discrimnatory burdens of the double taxation of dividend income is not possible. A long-range and comprehensive point of view is necessary to restore as close an approach to the neutrality that would exist in the absence of any income tax as may be feasible. No perfect solution is available. We must select the best among the imperfect alternatives. Among the most obvious methods of relief are (1) elimination of the corporate tax, (2) elimination of any tax on dividends, (3) some adjustment in the corporate for dividends distributed, in recognition of the individual tax to be paid on them, or (4) some adjustment in the individual tax for dividends received, in recognition of the corporate tax previously paid. The first alternative is not acceptable because it would mean that retained earnings would be completely untaxed, as well as all corporate income distributed to tax-exempt organization or individuals whose income is below the taxable level. In this country, at least, corporations are regarded as separate taxable entities; historically, the corporation income tax was in effect for 4 years from 1909 before the individual income tax was first enacted. Though there are many bad results from a too high income tax, the tax has come to have a place in our revenue system and any proposal for its elimination should be considered on its merits and not simply as a device for alleviation of double taxation.

The second alternative, the elimination of the individual income tax on dividends, is also unacceptable as long as individual tax rates

go above the corporate rate. If dividends were not taxed to individuals, they would escape the full effects of those surtax rates which exceed the corporate rate. This might be useful to induce risk investment, and help to counteract the pernicious effect of tax-exempt bonds, but it cannot be advanced under the guise of relief from double taxation.

From some points of view there is much to be said for the third alternative, some adjustment in the corporate tax for dividends distributed, in view of the fact that they will be taxed in the hands of the individuals receiving them. A full deduction in computing corporate taxable income for dividends paid would seem at first sight to give complete relief. Retained earnings would be taxed to the corporation at a flat rate and distributed earnings would be taxed to individuals at their respective personal tax rates. From this point of view, the solution appears perfect. A deduction for dividends paid might also be thought of as balancing the deductibility of interest, and hence securing tax neutrality between debt and stock financing. But from other, and more significant, points of view this approach to a solution is not good and does not achieve its intended objectives. If dividends are deductible, the corporate tax becomes a tax on retained earnings, and retained earnings are by far the most important source of equity capital for industry in this country. What is intended as relief for dividends paid becomes a penalty on earnings retained. For those companies which have to retain all or virtually all of their earnings there is no relief-to be sure, there is by definition no double taxation and hence perhaps no need for relief in this case. Nonetheless, a corporate tax solely on retained earnings would surely be regarded as a penalty on growth.

More significantly, the deductibility of dividends would not really equalize the tax status of debt and equity financing unless all earnings were distributed. Dividends paid are only superficially a measure of the cost of equity financing; the dilution of prospective earnings per share is the more significant measure of cost of new capital. When funds are secured by debt, the interest payable is a proper measure of the cost, and the deductibility of the interest keeps the corporation income tax from influencing the cost. But, when funds are raised by stock, there must be sufficient earnings on the new capital to maintain total earnings per share on all the stock if dilution of the existing stockholders' interests is to be avoided. To the extent that earnings are not distributed, the corporate tax would not be made neutral as between debt and stock financing. The relief would be greatest in mature companies and least in growing companies which typically retain a higher proportion of their income. The deductibility of dividends accordingly falls short of being the ideal method of relief. It does not produce neutrality between debt and stock financing, except in rare cases, and it makes the corporate tax subject to the criticism that it is a penalty on retained earnings.

In one respect, however, the deductibility of dividends is logical and theoretically preferable to any other method of relief, including the method now in effect. Dividends on preferred stock are much more similar to interest than to dividends on common stock. The corporate income tax does not rest on preferred stock, even if the tax rests fully on the corporation. So long as there is enough income after tax to pay the preferred dividends, the burden falls entirely on

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