Dividend Taxes Part III: Empire-Building
This is long, but hopefully not too boring. If you are in a hurry, skip down to the bold-faced paragraph and read from there. Quoting from an earlier post, dividend taxes “do discourage firms from distributing profits to shareholders. And, as it turns out, when firms don’t distribute profits to shareholders they quite often do very silly things with the money. When this happens, it’s bad for the firm, bad for the shareholders, bad for the employees of the firm, bad for the stock market, and bad for the economy.”
What are these “very silly things” that firms (particularly, their CEO with the advice and consent of the board) do? Almost always, it is excessive acquisitions and unrelated diversification. Simply put, most firms are better when they center their activities around a small set of activities and then do that well. That small set of activities is what MBAs and consultants call a firm’s “core competency”. “Unrelated diversification” refers to a firm moving from it’s core competency—via acquisition or expansion—into areas not in the core.
We might say that, in 1998, AOL’s core competency was making the internet experience easy enough for your grandmother to use (and they were and remain quite skilled in the art of mailing me CDs). Similarly, Time Warner’s core competency was in something like content production and distribution. The important question for the owners of these two firms, the shareholders, is whether these two competencies go better together (the merger involves real “synergies” or “complementarities”) or whether they are best done separately (the merger is “unrelated diversification”).
Coming up with theoretical synergies between the two is not too tough: the web and TV will converge someday, AOL knows the web and Time-Warner knows TV. But watching AOL-TW in the post-merger years there were very few actual examples of synergies (Instant polls? Crawlers on Talkback Live of Instant Messages? Whoopee!). Instead, you had AOL people worrying about the TW business and TW people worrying about the AOL business. TW’s flagship, CNN, gets passed by FOX News. AOL’s growth rate stagnates, and the two are less valuable together than separate. Management’s focus is spread too thin.
An example of the phenomenon in reverse: when Lou Gerstner took over for IBM in the 1993, IBM was in a lot of trouble, business was lagging, and it faced a serious cash crunch. Part of the problem was that IBM was in hundreds of unrelated lines of business and there was no coordination across even the related lines of businesses. So Gerstner came in and sold off non-core businesses, reorganized around product lines instead of geography, implemented incentive pay, and cut costs. Note to Naderites, yes cutting costs means layoffs. In this case the alternatives were probably bankruptcy or a government bailout. By 1996, IBM was back on track .
How does all of this relate to dividends? The AOL-TW management expanded their empire, while Gerstner shrunk his empire. Broadly speaking, CEO’s are aggressive, confident, and competitive; they wouldn’t make the top levels of business if they were not. When a company has profits above those required to sustain core lines of business, the CEO and the board have to decide whether to “Empire-Build” in the style of AOL-TW or distribute those profits to shareholders in the form of dividends. If you look at mergers and acquisitions over time, you really do see too much “Empire-Building” and not enough “Value-Creation”. In most cases, the explanation is a combination of hubris and a misguided desire for diversification.
Jensen believes that most current mergers undertaken to reduce excess capacity and combine related services (such as the recent Chemical/Chase merger in the banking industry) will ultimately be successful. Those associated with growth and so-called synergies – such as the Time Warner acquisition of Turner – will ultimately be viewed as unwise.
Today’s activity, he notes, is more like the “disastrous” merger wave of the 1960s, which saw “large firms run by managers who, with little of their own money at risk, were spending corporate resources on ill- conceived diversification and empire-building campaigns.” “Unfortunately,” Jensen concludes, “too much of the current M&A; activity falls into the latter category.”
A final example: Goodyear (Tires). In 1984, they were very profitable. They decided to take those profits and invest in a pipeline; over the next two years, they spent over $1 billion. They also tried twice to buy into the helicopter business. What possible skills did managers who know the tire business bring to either the pipeline or helicopter business? None. Goodyear never made money on the pipeline and eventually sold it for $420 million in 1995; while they were doing this (the late 1980s) their tire business went bad. No synergies were ever posited by management, only a (misguided, see the postscript) desire for diversification. This is about $1 billion that should have been paid out to shareholders.
What mechanisms exist to discourage empire-building? If a company commits to paying dividends, then there will be less money to spend on spurious mergers and acquisitions.
Hence the logic of eliminating the tax on dividends: Taxing dividends gives managers an incentive, even an excuse, to retain cash rather than give it to shareholders. Then, rather than let it sit, they spend it on acquisitions and diversification. More often than not, these go bad (Next time you see an acquisition announced, look what happens to the buyer’s stock price). If instead, companies pay profits out to shareholders in the form of dividends, those shareholders can invest it where they see fit.
Is eliminating the dividend tax the only way to discourage empire-building? No. Using incentive pay helps a lot because it ties compensation to the company’s stock price, so there’s less incentive for top management to engage in unrelated diversification (there are problems with stock options, but that’s another topic). Another way to limit empire-building is to have independent Boards of Directors—directors not chosen by or involved in any way with the CEO or other top managers. Because the board must approve the CEO’s major decisions, if the board is independent they will act more in shareholders interests. Increasing the independence of boards is one part of the post-Enron, post-crash, set of reforms. But nothing has yet passed on this front, to my knowledge.
Even Bush cited, or at least tried to cite, the empire-building issue:
“We may not be cash-flowing that much, but the sky’s the limit. Well, when you pay dividends, that sky’s-the-limit business doesn’t hunt.”
Translated into English, I suspect that this would be the first salient and accurate statement about dividends that I’ve heard from the President. Of course, given the choice of two ways to limit “sky’s the limit” businesses, one that disproportionately benefits the wealthy (eliminating dividend taxes) and one that benefits all shareholders (corporate governance reform), which do you expect this administration to pursue?
In summary, eliminating the tax on dividend income would improve the performance of companies, by limiting their follies. This would be good for employees, the shareholders, and the economy. And it could be done in a revenue-neutral fashion. I’m sure wiser proposals could be crafted, but here’s one off the top of my head: eliminate the dividend tax and impose offsetting tax increases on those who benefit from eliminating the tax. In this case, an increase in the corporate profit tax and/or an increase in the top marginal tax rates could be imposed to offset the revenue loss from not taxing dividend income. The wealthy lose money (more income taxes) and gain money (no dividend taxes), netting out near zero. But the incentive for corporations to waste money on unrelated diversification is reduced in the process!
P.S. Isn’t diversification a good thing for firms to do? Don’t they reduce the volatility of earnings by operating in different lines of business? Yes, they do, but that is not a good thing for shareholders because shareholders can achieve their own diversification by, for example, buying mutual funds. Let the managers build the business and let the shareholders diversify.