Our solution to the Economic Crisis
The economic problem in the America has been a tale of two cities. For most of us, at the personal level individuals are seeing the pinch with real wages falling, unemployment at almost 9%, and rising food and gas prices. All the while, house prices continue to fall and economic uncertainty remains. On the other hand, corporations are thriving. Although they have recently run into headwinds, in 2010 the stock market recorded a total return of 17.9 percent, but this was compounded on top of a 29.3% return in 2009. Corporations have managed to increase worker productivity, without hiring, resulting in record profits. Publically held US corporations are now estimated to be sitting over $2 trillion in cash and cash equivalents. Two companies, Apple and Microsoft are each sitting on approximate $40 billion a piece (that billion with a "b"). Compounding problems, the uncertain economic situation means corporations aren’t sure whether to reinvest in anticipation of an expansion (action that could initiate a recovery on its own), or to hunker down in anticipation of a potential double-dip recession. As we can see from their growing pile of cash, more often than not, companies are doing the later.
It is no mistake that economists say that the economy has "stalled". The three big drivers of economy are individuals, corporations, and the government. When any of these spend, they create a multiplier effect. A company spending on a piece of new equipment results in additional payroll, taxes, and purchases from suppliers. Additional payroll means the consumer spends. Taxes give the government the means to spend. Rather, this circle of cash flow has been broken. To get it moving again, the government tried to prime the pump with stimulus money, which was deemed either too little by Democratic Keynesians economists and too inefficient by Republicans who believe the allocation of capital is best done by the private sector. The Republicans have proposed the alternative of tax cuts for companies, which will result in less revenue for the government to spend and more profits for companies which continue to show no signs of investing or getting money to the consumer through wage increases or additional hiring. Rather than have corporations sit on that cash, we would like to see this returned to investors or put to work through reinvestment. Our solution is to provide a temporary amnesty for dividends for certain types of corporations and combine it with a tax holiday for repatriated profits currently being held overseas by US corporations.
Dividends are classified either as ordinary dividends or as qualified dividends. Ordinary dividends are taxed at the ordinary tax rates for their tax bracket and qualified dividends are taxed at a 15% percent rate. To be eligible as a qualified dividend, the dividends must be from a domestic corporation or a qualifying foreign corporation and you must hold the stock "for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date," according to IRS publication 550. However, we would eliminate this dividend tax for both ordinary and qualified dividends for a period of two years for all "C" corporations.
Why only "C" corporations? This gets a little technical, but bear with us. There are multiple types of corporations but "S" or Limited Liability Corporations are taxed once on profits - at the end of the corporate year when any profit (or loss) is assigned proportionally to each investor according to their holdings. As an example, let's take a Limited Liability Corporation law firm which makes $10m in profits and there are 10 equal partners. The partnership might choose to retain $3m in profits for growth and distribute $7m to the partners. However, the partners pay tax on the whole $10m and the other $3m is considered additional paid-in capital. This is ideal for partnerships or tightly held stock companies, but unsuitable for large and publically held corporations. So the advantage of being a "C" corporation is that you can be a publically held corporation, but you become subject to additional regulations and you get taxed twice. The "C" corporation is taxed on its profits (at approximate a 35% rate, although the effective rate is substantially lower) and then the individual is taxed on the dividends. By limiting this to "C" corporations we eliminate the double taxation problem, which many believe to be inherently unfair, and we avoid the moral hazard of individuals or groups creating "S" Corporations or LLCs for the sole purpose of sheltering income.
As mentioned, companies are reluctant to expand, unsure of the direction of the economy and (for now at least) they are just sitting on the cash. They can give money back to shareholders, but shareholders are often reluctant to accept dividend payments due to the tax consequences already discussed. Another solution is a stock buyback, when companies buy publically held stock and retire it. Unless the company's underlying business fundamentally changes, the market cap of the company usually doesn't change, rather with fewer shares available the price of the existing shares rise. This is a way of returning shareholder value without shareholders having to pay taxes (at least until stock holders sell their stocks, when they have to pay capital gains tax). A final use of cash is to consolidate an industry through the acquisition of competitors or to expand into other lines of business through acquisition.
Studies have shown that companies' acquisitions tend to be dilutive. According to an extensive study by Wharton of 1,500 acquisitions over a three year period, "there was a transfer of wealth from acquirers to targets." In many ways, this makes sense, especially for publically traded companies. If one is to believe that the markets place a fair market value on the company based on all the information publically known, then the company should be worth whatever the current trading price is. Whenever a company acquires another, they will most likely achieve a certain degree of financial improvements based on synergies and cost savings. For example, if a company that sells peanut butter acquires a company that sells jelly, it may be able to cross sell both products to each other's customers, reduce the number of store shipments made, reduce some back-office staff, and some customers may be willing to pay a premium to single source both products. These are often categorized as "goodwill", and all too often the company executives overstate and over value these synergies as a means of justifying the acquisitions.
The problem with a stock buyback is that the sellers of the stock are voluntarily selling their stock on the open market. Most are in the process of rebalancing their portfolio, lock in gains, or minimize losses. It's estimated that up to two-thirds of all stock trades are made through proprietary automated high frequency trading system. These are not buy-and-hold traders, rather traders trying to lock in microscopic gains on a massive scale. Even individual stock holders are not likely to reinvest. On the individual level, a stockholder selling 100 shares of stock is likely rebalancing their portfolio. What we are trying to achieve is to have a "windfall", an unexpected payment given to owns of mutual funds or individual stocks that is not already earmarked for another purchase.
So without a viable alternative, companies have little shareholder pressure to do anything more than sit on cash reserves. With our plan, companies with excess cash would be pressured by stockholders to pay out the cash in the form of dividends. For individuals, getting (for example) $300 of money unexpectedly from a dividend from a mutual fund or individual stock, would likely result in consumer purchases. For institutions and retirement funds, this money would likely be reinvested, but would force a rebalancing of their portfolio. Money that may have been tied up in an underperforming stock could be reinvested in a high growth stock - creating a more efficient use of capital. Since innovation usually comes from start-ups, and are less likely to come from established players, dividend money from Microsoft (for example) could be reinvested in Linked-In, Facebook, and other social media startups - creating a better allocation of resources. These startups are in growth mode (vs. value companies) and would use the money to fuel their rapid expansion (employment).
Historically we have activist investors that pressure companies to either put cash to work or return it to investors. Hedge Funds often buy companies and have them pay out dividends; sometimes even forcing their captive companies to borrow against assets to pay large dividends. Certainly, with no taxes on dividends, investors will be doing the same - pressuring companies to either put money to work or pay it out in dividends. Which brings us to the second option - if they don't return it to shareholders, they can invest it. Faced with this choice, companies may choose to put the money to work, accelerating expansion plans or reinvesting in capital intensive projects. Either way, money will be spent providing a kick-start to the economy.
As a kicker, we would include in our solution a tax holiday for US corporations that repatriate profits currently being held abroad. This was done before, in 2004, when the corporate tax rate was reduced from approximately 35% to approximately 5% for profits moved back into the US and the repatriation rate increased eight times over normal levels. According to a Congressional Research Service report, "there is some empirical evidence, however, that the repatriations were used to return money to shareholders though stock repurchase programs." The report goes on to say that it "...found that a $1 increase in repatriations increased stock repurchases by $0.91, a use prohibited under the American Jobs Creation Act. (Note that because of the fungibility of money, firms that use part of the repatriation to repurchase shares may not violate the law.)"1 As mentioned above, most stock buy-back plans purchase stock in the open market, providing a temporary windfall to those planning to sell anyway, but don’t create any broad based cash "windfall" to investors.
Not only does it appear that the government not thinking about following our advice, there is a built in sunset of existing laws (the Bush tax cuts) that will cause dividend payments to rise. The special tax rates on long-term gains and qualified dividends will expire on December 31, 2012. Starting 2013, the tax rate on long-term gains will be 20% (or 10% if a taxpayer is in the fifteen percent tax bracket), the distinction between ordinary and qualified dividends will disappear, and all dividends will be subject to the ordinary tax rates. Also beginning in 2013, due to Obamacare, capital gain income will be subject to an additional 3.8% Medicare tax. HR 4872 modifies the health care act to impose an expanded 3.8% Medicare tax on investment income for people with income over $200,000 (or $250,000 for joint filers) called the unearned income Medicare contribution tax. Investment income for the purposes of the Medicare tax base would include interest, dividends, royalties, rent, passive activity income (such as income passed-through from partnerships and S-corporations), and gain from the sale of property.
With these changes right around the corner, now is the time for Republicans and Democrats to come together and embrace a temporary amnesty on the dividend tax, combined with a tax holiday to allow companies to repatriate overseas profits. Republicans can claim a tax cut, while Democrats can claim a second stimulus - this time funded by corporations rather than the government. If even half of the cash being horded by corporations were either returned to stockholders in the form of dividends or reinvested in their businesses, the $1 trillion would act as the second stimulus that both sides could agree on.
