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Tax System Favors Dividends over Capital Gains

With tax day (April 15th) looming, I have an excuse to talk about taxes a little more. I've learned a lot about taxes this year, unfortunately, because my tax preparer screwed up my taxes. (They fixed it professionally, so I'm not going to give them bad publicity over it.) One of the things I realized is that the tax system creates a small incentive for dividends instead of capital gains.

It's also an excuse for me to use Don Lloyd's Transparent Envelope Company as a didactic example again, which is always fun.

Imagine a company with $100 in cash assets, and nothing else. The company doesn't do anything. No storefront, no products, no revenues, no expenses. It's just a holding company. Its $100 in assets are stored in a transparent envelope. This company has issued 100 shares of stock, and because the company is so transparent (pun intended) and easy to understand, the shares are obviously valued at $1 each.

Magically, the company earns a $5 profit. The source of the profit is irrelevant here. Ignore the fact that my description of the company makes profits impossible. Trust me, it's magic.

The company's assets are now $105. If it retains those profits, its stock price will rise to $1.05 — a 5¢ capital gain. If instead it pays a $5 dividend (5¢ to each share), the stock price will remain $1.

As an investor, do I have any preference? I'm seeking the highest yield. Who do I believe will make the greatest return from that $5 — the company, or myself investing it somewhere else? My belief establishes my preference. If I believe I'll earn more, I want the dividend. If I believe the company will, I prefer it retain the earnings.

Taxes make this complicated. In the case of the Transparent Envelope Company, it's easy to see that both dividends and capital gains are double-taxed — first as profit to the company, and later as income to me. Dividends are taxed immediately, but capital gains are only taxed when they're realized, so the tax system raises the relative yield for retained earnings due to their (partially) untaxed compounding. This incentive favoring capital gains is fairly obvious, but isn't the one I wanted to talk about.

There's a different incentive, and it favors dividends.

It exists, ironically, because capital gains are taxed. Because gains are taxed, losses are tax-deductible. But the tax rates for dividends and deducted losses are unequal!

Let's modify the earlier example to add a magical asset loss of $1. (Let's say a horrible industrial accident smudged the transparent envelope, and it cost $1 to replace.) If the company paid the $5 dividend, its assets are now $99. If the company retained the earnings, its assets are now $104.

What happens if I liquidate my position in the Transparent Envelope Company?

In the dividend case, each share netted me a 5¢ dividend (taxed at 15%) and a 99¢ sale representing a 1¢ capital loss (deductible at, say, 25%.) Total value of $1.04/share, and a net tax of 5¢×15% - 1¢×25% = 0.5¢/share.

In the retained earnings case, my total value is again $1.04/share, but each share had a 4¢ capital gain. If it was long-term (15%), my net tax is 0.6¢/share. If it was short-term (25%), my net tax is 1¢/share.

Interesting, isn't it?

Despite the title of this article, I don't know whether the compounding incentive or the loss-deductibility incentive is larger when you're unsure which direction the stock price is headed. But if you do have an idea which way the stock price is headed, these incentives are present: if you believe the stock price will rise, you'll want capital gains so you can take advantage of untaxed compounding. If you believe the stock price will fall, you'll want dividends so you can take advantage of capital loss deductibility.

Why would I ever invest in a company when I believe its stock price will fall? If it's deliberately decumulating capital by paying dividends in excess of profits, it may make sense. The share price will fall, but the dividend will protect your total return. And you get this nifty tax benefit.

If the Transparent Envelope Company had no profits but simply started paying a $5 dividend, it would eventually liquidate itself. Each share would pay out $1 in total dividends (+15¢ tax) but also have a capital loss of $1 (-25¢ tax), for a total after-tax result of $1.10.

Once more, with feeling: Interesting, isn't it?

Tiny Island