Double-tax directly

The finance minister argues, with some justification, that the tax paid by companies on dividends that they distribute is really tax that is paid on behalf of the shareholder who receives that dividend, and this should not therefore be added to the corporation tax burden borne by the company. In practice, though, a direct tax that is not passed on to someone else is in most people's eyes a tax on the entity paying the tax; so, many companies will in fact view the burden of corporation tax and dividend distribution tax in their entirety as one combined burden. And now that the dividend tax rate has been hiked, and no set-off is provided to prevent cascading of tax in the hands of companies that have subsidiaries, it may be time to review the whole scheme.

The theoretical justification for not taxing dividends in the hands of the person receiving them is that it amounts to double-taxation, since the dividend is distributed out of profits that have already been taxed in the hands of the company. The counter-view has been that each shareholder is a separate entity from the company, and taxing dividends is not therefore a case of double-taxation. The dividend distribution tax is a halfway house; it sticks to the principle that double-taxation should be avoided, but makes a bow to the counter-argument by taxing that part of the profit that is paid out to shareholders.

So long as the dividend tax was at a modest level of 10 per cent, most people were willing to live with this fudge. But now that the tax rate has been raised in stages to 15 per cent, it begins to acquire the size of a full-scale impost and prompts the question: why not simply revert to taxing dividends like any other income, perhaps with a separate tax exemption floor in recognition of the fact that many people would see this as reversion to double-taxation? Such a switchover would have several benefits. First, it would put an end to the accusation that "unearned income" in the hands of some of the wealthiest people in the country was going tax-free while ordinary working folk were paying their full share of tax. This is the equity argument. Second, it would improve the post-tax profit picture for companies""and thereby perhaps help their stock market valuations. That is the capital market justification.

A switchback to taxing dividends in the hands of the shareholder would also be good for corporate governance. The fact is that the dividend distribution tax encourages companies to pay as little by way of dividend as the shareholders will tolerate, and to retain profits as much as possible because that reduces the tax burden on the company. This can lead to aggrandisement by company managements, which start using shareholder money to undertake investments that might not have been fully justified from the perspective of the return on capital employed, but are undertaken anyway because the company has the accumulated reserves to invest. Shifting the burden of dividend tax on to the shareholder would therefore work towards improving corporate democracy, by encouraging managements to return a larger part of the profits earned to shareholders.