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Sat, Aug. 24

Lets get rid of incentives for bad behavior

(EDITORS NOTE: Steve Chapman is on vacation. The following column was originally published in May 2003.)

If you want to stop raccoons from getting into your garbage cans at night, you can combat the little beasts by putting out traps, baiting the trash with poison, chasing them away, or even shooting them.

But as soon as you relax your vigilance, you can be sure the varmints will be back making a mess. Luckily, you have another way to solve the problem: Dont leave the garbage out.

The various corporate scandals and bankruptcies have led to numerous prosecutions and demands for punishment of the guilty parties. But it may be more effective to get rid of opportunities and incentives for bad behavior. And that is one good argument for President Bushs efforts to eliminate or at least reduce the double taxation of corporate dividends.

Cutting taxes on the owners of corporations may not seem like an obvious response to executive wrongdoing. But Sen. Peter Fitzgerald, R-Ill., formerly an attorney for a bank holding company, said the administrations original proposal would have amounted to the most significant corporate reform since the creation of the Securities and Exchange Commission in the 1930s. Plenty of experts agree that by discouraging dividend payments, double taxation invites nothing but trouble.

Corporations with cash on hand have two basic choices as to what to do with it. They can give it to shareholders as dividends, or they can use it to acquire assets. They have a strong incentive not to do the former, because the law doesnt allow them to deduct dividend payments from their taxable income. As a result, the government taxes dividends twice: as income to the company, and as income to the shareholder. The combined taxes can take up to 60 cents of every dollar paid out.

So shareholders are content to see the company reinvest their money in the hope that it will raise the value of their stock. Dividend payments, which used to be the chief reason for buying stocks, have sharply declined.

Thats fine with many corporate executives, who prefer to retain earnings to spend as they see fit. But what they see as appropriate may not match your definition of the word. Veteran mutual fund manager Ralph Wanger, who runs the highly respected and successful Acorn Fund, quips that managers enjoying excess cash have two major ways of handling it: One is to steal it; the other is to waste it.

In one corporate meltdown after another, theyve proved to be unreliable custodians of the shareholders money. WorldCom founder Bernard Ebbers bought companies more often than most of us buy coffee. He made no fewer than 75 acquisitions in an empire-building spree that helped produce the biggest corporate bankruptcy in American history.

Tyco Chief Executive Dennis Kozlowski allegedly spent hundreds of millions of dollars of the companys money on bonuses for himself, as well as a host of other goodies for the Kozlowski family. Adelphias founders stand accused of using company money to finance a lavish lifestyle. The company founded by Bernard Ebbers lent more than $400 million to Bernard Ebbers.

At the same time, lots of corporations made mistakes with borrowed money as at Enron, whose debt more than tripled between 1996 and 2001, and at Global Crossing, which piled up some $12 billion in debt en route to Chapter 11.

Oddly enough, current tax policy also promotes excessive borrowing, since interest payments are deductible, but dividends are not.

Excessive leverage may not be a problem in good times, but it can sink a company quickly in bad times.

Eliminating the tax bias against dividends would lead to more of them, which not only would enrich investors in the short run but deliver corporate executives from temptation. Dividends also have the virtue of providing tangible proof of a companys profitability.

In the old days, says Sen. Fitzgerald, dividends were the chief basis for judging the financial health of a corporation. Today, investors have to rely on other information that is harder to assess. Its possible to fudge earnings reports, it turns out. Dividends cant be fudged, he says. You have to pay dividends with cash.

Unfortunately, the compromise reached on Bushs tax bill left the double tax in effect. But it reduced the top rate investors must pay from 38.6 percent to 15 percent, matching the new rate on capital gains.

That change will encourage investors to demand more dividends and pressure corporations to pay them, putting money in the pockets of investors.

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