This article looks at the alternative methods that can be employed by firms with regards to rewarding equity holders. Economists have long been puzzled by why firms pay dividends when alternative methods of rewarding shareholders and financiers exist which involve less taxes. Dividend paying equity appears to be the most heavily taxed capital instrument available. It is subject to two levels of taxation: first, the federal corporation income tax (set at a 34 percent marginal rate in the U.S. as of June 1989) and second, the personal income tax if the shares are owned by households. Even with the new lower marginal tax rates of the 1986 Tax Reform Act, most household shareholders have marginal personal tax rates of 28 or 33 percent, meaning that the combined corporate and personal taxes on dividends exceed 50 percent. There are more lightly taxed alternative methods of finance. Equity which retains and reinvests earnings generates accrued capital gains on which taxes can be deferred until realization. There is even the possibility of completely escaping taxation on accrued gains if they remain unrealized until the asset passes through an estate.
Hodrick, Laurie Simon, and John Shoven. "Cash Distributions to Shareholders." Journal of Economic Perspectives 3, no. 3 (1989): 129-40.
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