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Daniel M. Holland, School of Industrial Management, Massachusetts

Institute of Technology


The first three sections following this introduction deal in some detail with these two questions:

1. What is the nature of the tax discrimination against dividend income? In addition, we examine the differential taxation of retained earnings and the whole of stockholders' corporate earnings (distributed and retained).

2. How appropriate is the tax relief currently provided dividends? What I have to say on both these points is neither new nor complicated. And yet, apparently, it can stand repetition, for these considerations have not been given their due accord in the most recent legislation affecting the taxation of corporate earnings—the dividend credit and exclusion introduced in 1954. That is not to say that this paper covers all the relevant issues, but those it does stress are too important to be ignored.

The discussion will, for the most part, treat the taxation of dividends (and, more broadly, corporate earnings) as a problem in equity, i.e., I shall view the central problem to be achieving (1) equality of tax liability between dividend recipients (stockholders) and other personal income taxpayers, and (2) the same degree of differentiation (progression) in the tax rates that effectively fall on dividend recipients at different levels of income as that which applies for all other personal income taxpayers. In other words, this part of the paper is concerned with eliminating or alleviating "double taxation," and not with the use of tax devices to encourage certain "salutary" or "desirable” activities, e.g., saving more, investing more, growing faster, etc. It focuses on tax equity rather than incentive taxation. And for this purpose it talks as if the corporate tax were neither shifted nor capitalized.

The rest of the paper discusses, in more cursory fashion, alternatives to the exclusion and credit, and the implications of the possibility that the corporate income tax may (to some degree at least) be shifted or the possibility that stockholders (to some extent) may have acquired their shares at prices that reflect a discount for expected future corporate tax liabilities.

NOTE:--This paper draws on materials prepared by the author for his study of the income tax burden on stockholders at the National Bureau of Economic Research. How. ever, it is a purely personal effort and statement and has not undergone the National Bureau's usual review procedure.

Double taxation" of dividends

Taking into account both the distributed and retained components of the corporate earnings of a given year and relating them proportionately to stockholder claimants thereof, it may be said that at no time since 1913 has our income tax structure (corporate and personal combined) led to complete equivalence of tax liability for corporate earnings and other categories of income. But, for the distributed component of corporate earnings, i.e., dividends, equivalence was initially sought.

The personal income tax act of 1913 exempted dividends from normal tax. Both the tax rate on corporate income and the normal tax rate on personal income were set at 1 percent; thus, for distributed earnings the corporate tax operated as a withholding feature of the personal levy. This treatment continued through 1918, as increases in the personal normal rate were matched by increases in the corporate rate. But from 1919 on, the corporate rate exceeded the personal normal rate and thus the corporate tax became, in part, a separate and distinct levy on distributed corporate earnings. The rate gap widened gradually until 1936 when the bridge between the two taxes was removed completely by the abolition of the dividend exemption. A return to something like the 1919–36 procedure was instituted by the Internal Revenue Code of 1954 in the form of a tax credit based on dividends received. But here, too, a substantial gap exists between the personal income tax credit and the rate of corporate tax. Therefore, since 1919 the distributed earnings of corporate enterprises have been treated differently from the other sources of income for Federal income-tax purposes: from 1919 to 1936, because the corporate rate was higher than the personal normal rate; from 1936 through 1953, because corporate earnings were taxed at the corporate level when earned with no allowance at the personal level when distributed; and from 1954 on, because the personal income-tax relief accorded distributed earnings falls short of the corporate tax rate.

Of course, especially in the earlier years of the income tax, because both personal and corporate rates were "low," the failure to achieve a tax treatment for distributed earnings equivalent to that for other income shares might have had very "slight consequences. And, naturally, much more severe disparities could be expected with the rapid rise of tax rates in the last 20 years. Yet this has not really been the result for some stockholders. Before undertaking to state who they are and how this could happen, however, it is necessary to explain our conceptual procedures. This can most conveniently be done with reference to the situation that existed from 1936 up through 1953. Then the effect of the recent modifications in dividend taxation can be examined.

We are interested in developing a measure of the degree to which distributed corporate earnings have been differentially taxed. For

1 With these exceptions : A corporate rate greater than the personal normal rate in 1917, and greater than the rate applicable to the first $4,000 of normal tax income in 1918.

. The main outlines of the conceptual framework that follows are not novel. In setting it up. I have drawn on the work of previous investigators, in particular: Richard B. Goode, “The Corporation Income Tax," Wiley, 1951, and "The Postwar Corporation Tax Structure," Treasury Department, Division of Tax Research, 1946; W. L. Crum, “The Taxation of Stockholders," Quarterly Journal of Economics, February 1950.

The considerations set out here are discussed at greater length in Daniel M. Holland, "The Income Tax Burden on Stockholders," Princeton University Press for the National Bureau of Economic Research, 1958, ch. 1.

simplicity, we neglect initially the dividend exclusion and credit introduced in 1954. These relief provisions will be picked up after the nature of the discrimination against stockholders has been spelled out. Consider then, as was actually the case from 1936 through 1953, dividends as subject to the full panopoly of personal income tax rates upon receipt by the stockholder, while the earnings out of which dividends were paid had already been taxed at the corporate level. This differs from other corporate distributions like wages or interest which were free of corporate tax. Hence the charge of "double taxation of dividends.” But this charge interpreted literally is wrong, since it is not dividends but the earnings that enabled their payment that were taxed twice. And it is not very informative since it seems to suggest an equally onerous extra burden for all stockholders.

For our problem, dividends are not the relevant component of stockholders' income. Rather, in estimating the reduction in potentially disposable income caused by this tax, we must work with the pretax equivalent of distributed earnings, to which we give the title of earnings for distribution. Assuming, for simplicity, a corporate tax rate of 50 percent; then for every dollar of dividends paid out, corporations must earn $2. If a given stockholder, therefore, has $100 of dividends, the earnings for distribution component of his income will be $200. The difference between earnings for distribution and dividends measures the corporate tax on the distributed segment of net corporate earnings. To this is added the personal income tax on dividends (considered an increment to the stockholder's taxable income from other sources) to obtain the total income tax actually levied on earnings for distribution.

But this does not measure the differential taxload. For the personal-income-tax payer is not deprived of an amount of potential income equal to the corporate taxpayment on earnings for distribution. Had this sum been paid to him instead of to the Government, it would have been taxable as personal income. So it is only the difference between the corporate tax and the product of the corporate tax multiplied by the marginal rate of personal income tax that represents the extra burden on stockholders' earnings for distribution. For example, with the corporate rate at 50 percent, every dollar of earnings for distribution bears a 50-cent corporate tax, but had this 50 cents been paid to stockholders it would have represented something less than a 50-cent addition to their personal income after tax. If the relevant marginal rate is 20 percent, the deprivation due to the corporate tax will be 40 cents; if the potential marginal rate is 90 percent, the corporate tax causes a loss of potential disposable income of only 5 cents. Thus, the potential personal income tax on earnings for distribution is computed and subtracted from the actual combined corporate-personal income tax on that component of stockholder income to find the net extra burden on the distributed portion of net corporate earnings. For comparison among income levels and between years, the absolute extra burden can be converted to an incremental effective rate by taking it as a percentage of the earnings for distribution component. We call this measure the differential against earnings for distribution.


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The derivation of the measure may be summarized symbolically as follows (for simplicity, all rates and differentials are expressed as ratios) :

Ce=effective rate of corporate tax on earnings for distribution
D=dividends received
E =earnings for distribution; E-C.E=D
P =applicable marginal rate of personal income tax
Ne=absolute extra burden on earnings for distribution

differential against earnings for distribution Then


=CE (1-P)

Ce(1-P) Since P rises as stockholder income rises but never reaches 100 percent, the differential against earnings for distribution is a declining function of stockholders' income, but always positive. In relation to the distributed segment of net corporate earnings, then, the corporate tax constitutes a burden that is always smaller than its face amount, a burden that varies inversely with the level of stockholders' income.

An historical review of the magnitudes of this "discrimination" against stockholders, and an indication of what it would be like currently without the relief provided in 1954 appears in table 1. Of most immediate interest, of course, are the entries of the last line, for they show the current situation sans credit and exclusion and form the basis, therefore, for evaluating the appropriateness of these relief measures. They illustrate the particular magnitudes that go with our general statement of a “discrimination” that declines in relative severity as stockholder income rises. The magnitude of the discrimination before relief covers quite a spread-from over 41 points of extra tax at the lowest taxable income to an added burden of under 5 points of tax at the highest. The actual range is even wider than this. For outside the purview of our tables fall those most heavily "overtaxed" stockholders with income too low to be taxable or institutions who are expressly exempt from income tax. Their share of earnings for distribution was subject to the corporate tax, while a zero personal rate would have applied to them. They are, then, effectively taxed at the corporate rate with no offset. In all other cases, however, the burden of the corporate tax is offset by the personal tax that would have applied.

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TABLE 1.-Differential against a marginal dollar of earnings for distribution at

selected taxable income levels, 1936-591

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$1,000 $3,000 $5,000 $10,000 $25,000 $50,000 $100 000 $500,000 $1,000,000

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I From 1948 on, the different are based on the rates applying to joint returns. • Effective rate limit of 90 percent operative here and used as marginal rate in our calculations. NOTE.-In computing these differentials, we used the highest combined corporate normal and surtax rate each year but took no account of excess profits taxes.

While our concern is directly with the problem as it stands now, a brief review of trends in the differential is illuminating. For this purpose, four "typical” taxable income levels are chosen : $1,000 to symbolize low; $5,000 and $50,000 to stand for lower middle and upper middle, respectively; and $500,000 to represent the top of the income range. Remember that if we start with 1936 the trend in tax rates, both corporate and personal, was up for about 10 years and then bounced around for a while, remaining quite high over the rest of the period. Against this background, what happened to the "extra" burden on distributed corporate earnings? The answer differs, depending on the income level we are looking at. In the lowest bracket of taxable income, the trend was a sharp rise in the differential-from 14 points of extra tax in 1936 to over 41 in 1959 (before exclusion and credit) or, if one prefers, to over 40 points in 1953. Much the same is the story at $5,000 of taxable income, except that, because higher personal income tax rates applied here, the starting and terminal differentials were slightly lower than at $1,000. At $50,000, too, the differential became sharper over time, but' here the level was considerably lower than further down the income scale and the growth not as sharp. At $500,000, a comparison of the starting and ending years shows little change in the discrimination over time, albeit a higher “extra” burden over most of the period following 1936 than in that year itself. Why this moderate "overtaxation here and its failure to vary much (compared with other income levels) over time? The push-pull relation between corporate and personal rates is the explanation. Given the personal rate, the higher the corporate rate, the higher the differential. While given the corporate ratē, the higher the personal rate, the lower the differential. The same relation applies, of course, when both rates rise or fall together,

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