The Heritage Foundation

WebMemo #248 on Taxes

April 3, 2003

April 3, 2003 | WebMemo on Taxes

Everyone Profits from Hurdling Dividends

Why would ending the double tax on dividends encourage economic growth and thereby benefit most Americans?

To understand why, it is helpful to imagine being a corporate manager. Before investing in buildings, equipment and machinery, managers estimate their expected profits using a concept known as the "hurdle rate." How exactly does this work?

To estimate a project's return (or profit), managers compare the amount of money they expect the project to bring in to the cost of the funds (the capital) needed to undertake it. To be profitable, therefore, the project's rate of return must be greater than the firm's cost of capital. Otherwise, the project would be expected to lose money and, as a result, not be carried out.

The firm's cost of capital, therefore, is the hurdle rate - the cost that must be exceeded for a project to be profitable. The hurdle rate can also be thought of as the minimum profit the firm has to return to its investors. When a project's rate of return is greater than the firm's cost of capital, it clears the hurdle rate; the project will be undertaken because it is profitable. This is why dividend taxes are so damaging. Dividends represent a part of the firm's cost of capital. When investors buy stock, they expect to receive dividends.[1] The dividends that have to be paid to investors, therefore, represent a part of the firm's cost of capital. Consequently, lowering the tax on dividends will make it easier for managers to return money to investors because it lowers the cost of doing business and undertaking new activities.[2]

When the cost of capital falls, business managers will increase their firm's investment in equipment and buildings.  Increasing investment frequently results in new jobs, and these new jobs and the new purchases of business mean higher incomes for many more people than those who work directly for the business manager. Over time, these effects of lowering the cost of capital through ending the double tax on dividends leads to higher economic growth and widespread economic benefits.  

[1] Actually, they expect to receive dividends and/or capital gains. Still, even a capital gain can be thought of as a dividend; both represent an expected cash payment to the investor.

[2] As long as the managers act in the best interest of their shareholders, this relationship holds for all firms with existing equity capital who either pay or have the potential to pay dividends.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Related Issues: Taxes