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A Tax Bias toward Mega-Corporations

2 min readBy: Alan Cole

Corporations operating under value-based management are motivated by the desire to return the maximum return to shareholders. A corporation with this goal in mind faces an incentive to become larger than optimal, because of the way that the taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code treats capital income for individual investors.

Corporations generally return value to their shareholders in one of two ways: they can distribute profits as dividends, or they can find new projects to spend money on and reinvest the profits in those projects. The individual tax code is slightly biased towards the latter option.

For individuals, long-term capital gains and qualified dividends are taxed at identical percentage rates. This parity is an illusion. It is far better to defer taxes on one’s investment income by carrying unrealized capital gains than to pay taxes immediately on dividends – even if the rates appear to be the same, you want to defer paying that rate as long as possible.

Savvy investors know this; they pour billions of dollars into funds like this one, focused on maximizing capital appreciation at the expense of dividends. These investors push corporations towards expansion and away from dividend distribution.

This sort of pressure, at the margin, leads corporations to make investments that should not be made. For example, consider McPizza – a failed attempt by McDonald’s to enter the pizza market in the early 1990’s. Pizza is great, but there is no particular reason to believe McDonald’s is the right corporation to make it. Pizza takes much longer to cook than other McDonald’s menu items, and it requires different equipment to create. The product was never very successful, and it was discontinued by 2000.

The world would have been a better place if McDonald’s had paid higher dividends instead of buying pizza ovens and advertising time for pizza people didn’t want. The money might then have been put to better use by other corporations – perhaps even one that actually specializes in making pizza.

But if McDonald’s had paid out a dividend, it would have subjected the money to an immediate round of taxation. In this way, the tax code favors projects like McPizza; it encourages companies to hold onto their capital instead of freeing that capital up for other companies to use. In a better world, it would be neutral between the two.