Commentary

Two Simple Cures for What Ails American Corporations

By William A. Niskanen
September 23, 2002

Enron, WorldCom, and company failed by making unusually bad business decisions — not by violating accounting standards. Almost all of the public debate about the failure of those large corporations, however, has focused on how to improve accounting standards and auditing procedures while ignoring how current government policies increase the frequency and magnitude of corporate failures. Without changing the policies that contribute to corporate failures, the primary effect of improved accounting rules and auditing procedures would be to speed up bankruptcies.

Corporations go bankrupt when they can no longer meet the obligations to their creditors. This is a result of some combination of unusually risky investments and unduly high debt. Bankruptcy is the limiting step in the process of reallocating capital, and the optimal number of bankruptcies is not zero. Current government policies, however, lead to a larger-than-optimal rate of bankruptcy.

The federal tax code is the major policy that increases the conditions that lead to corporate bankruptcy. First, the corporate earnings subject to taxation exclude interest payments but not dividends. This leads corporations to use more debt than would be the case if the tax treatment of interest and dividends were the same. The combined federal and state corporate income tax rate in the United States is now the fourth highest among the industrial nations, so one should expect American corporations to be unduly dependent on debt finance.

Second, for most investors, the tax rate on dividend income is much higher than the rate on long-term capital gains. This leads corporations to rely more on capital gains than on dividends as the return to equity. This bias also leads to several other adverse effects — reducing the cash-flow discipline to meet dividend payments, increasing the incentive to inflate the stock price, and increasing the role of corporate managers relative to investors in the allocation of capital.

The simplest way to reduce these two tax-related problems is to allow corporations to deduct one-half of their dividend payments from the earnings subject to the corporate income tax. This would make the combined corporate and personal tax rate on interest and dividends about the same for most investors without changing any other feature of the corporate or personal income tax code and would roughly eliminate those adverse conditions attributable to the current difference in those rates. Over the past several years such a change would have reduced corporate income tax liability by about $60 billion a year, substantially reducing the bias in favor of debt finance. Other tax revenues, of course, would increase due to an improved allocation of capital, increased corporate investment, and higher personal income tax revenues from increased dividend payments.

For those who would otherwise be opposed to reducing corporate income tax liability or considering any supply-side benefits of lower tax rates, the Cato Institute has long maintained a list of federal corporate welfare spending, the elimination of which would more than offset the reduction of corporate income tax liability.

Another important problem is that both the federal and state governments have passed many laws that protect corporate management against the interests of the general shareholders. The most important of those laws is the federal Williams Act of 1968, which requires any person or group that acquires more than 5 percent of the shares of a corporation to provide extensive information within 10 days to the corporation, the exchanges, and the Securities and Exchange Commission (SEC), including “if the purpose of the purchases or prospective purchases is to acquire control of the business of the issuer of the securities,” and increased the authority of the SEC to regulate tender offers. Following the Williams Act, the number of hostile takeovers declined in the 1970s and, following a series of court decisions and state anti-takeover laws beginning in the late 1980s, the number of hostile takeovers declined again in the 1990s. The primary protection of general shareholders against an abuse of authority by corporate management, thus, has been substantially eroded by public policy. The second simple cure for what ails American corporations, thus, is to begin to reverse this process by repealing the Williams Act of 1968.

A candidate for Congress who endorses these two simple cures — the deduction of one-half of dividends from the earnings subject to the corporate income tax and the repeal of the Williams Act of 1968 — -would be among the few to demonstrate that they understand what has happened to American corporations and the most important policy changes to restore their financial health and integrity.

William A. Niskanen, former acting chairman of President Reagan’s Council of Economic Advisers, is chairman of the Cato Institute.