Dividend Taxation and Corporate Governance

In 2003, the United States enacted a tax reform that reduced, but did not eliminate, individual dividend income taxes. Cutting the dividend tax deprives corporate insiders of a justification for retaining earnings to build unprofitable corporate empires. But not eliminating it entirely preserves an advantage for institutional investors, who can put pressure on underperforming managers. This balance is broadly appropriate in the United States—whose large companies are freestanding and widely held. In addition, preserving the existing tax on intercorporate dividends, in place since the Roosevelt era, discourages the pyramidal corporate groups commonplace in other countries, and preserves America's large corporate sector of free-standing widely held firms.