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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.

Here’s a nice excerpt from a randomly googled place (Jensen is a Harvard Business professor who spends a lot of time studying this issue):

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.

Exciting Opportunity

My contact email ( has only existed for 10 days. In the entire Internet, it is only posted here. What is the third email I get?

That’s right, an exciting opportunity to help embezzle funds out of Nigeria!













And so forth….By now, you would think there would be no money left to embezzle from Nigeria. More dividend taxes stuff today, really.


Continuing my not-yet-waning obsession with tracking hits to my site, I see that I am now the top Google hit for “the meaning of share buyback”, beating out, inter alia, the Motley Fool! (UK edition).


And on Ted Barlow, I caught this gem regarding the Presden’t recent speech in Georgia, which I mentioned here. Barlow refers to a Newsday story that leads with

There was only one problem with President George W. Bush’s claim Thursday that the nation’s top economists forecast substantial economic growth if Congress passed the president’s tax cut: The forecast with that conclusion doesn’t exist.


This AP story is somewhat amusing. Bush uses the press quite masterfully, but he really (1) doesn’t seem willing to answer unscripted questions (based on the paucity of press conferences) and (2) doesn’t want to be seen answering unscripted questions, as this quote illustrates:

White House officials promised a wide-ranging exchange, and as Monday’s meeting began Bush repeatedly said he wanted to work with the governors. As the meeting ended, he [President Bush] asked “Questions?” and then stopped as reporters were still filing out of the room before the meeting began. “Not yet, get the press out.”

Historically, the press does stay for the Goivernors’ Q&A with the president. In this case, the governors’ questions were not even unscripted:

Kempthorne, vice chairman of the National Governors Association, said he was confident the meeting would be open and constructive. He said he was asked to give the administration his question beforehand “so no one’s caught flatfooted.”

Just curious, but who is “no one”? How could anyone in the room other than the person answering, or attempting to answer, questions be caught flat-footed? In this case, the President’s strategists likely feared tough questions from governors facing massive budget shortfalls and, given the federal deficits, little prospect of a federal bailout (Federal bailouts may be a bad idea–why should any state ever balance it’s budget if the federal government will bail them out? But I digress). Bush gets positive coverage from the press, not just the op-ed pages, but in news pages. The New York Times’ Frank Bruni stands out as one of the more sycophantic, but in every story, the tone and tenor just feel positive as I read them. That’s subjective and you may disagree, but certainly it’s hard to argue that the press is hard on Bush. The point is that Bush gets good press while holding almost no press conference and while sending Ari Fleischer out for exchanges like this (I saw this on Alas A Blog):

Mokhiber: You said last week that, “Every step will be taken to protect civilian and innocent life in Iraq.” But Pentagon officials have said that under a battle plan called ‘shock and awe,’ “there will not be a safe place in Baghdad when we attack.” Baghdad is a city the size of Paris, with five million residents. If there will not be a safe place in Baghdad when we attack, then how do you plan to protect every civilian life?

Ari Fleischer: First of all, I think that any construing of any statements that are made by anybody at the Pentagon to suggest that the Pentagon does not and will not take every step to protect innocent lives is an unfair representation of what the Pentagon would say. It’s well-known how the United States conducts itself in military affairs. We are very proud of the fact that any time force is reluctantly used, the force is applied to military targets and innocents are protected.

The exchange comes from “Ari & I, White House Press Briefing with Ari Fleischer” by Russell Mokhiber. Here’s one more:

Mokhiber: Ari, two questions. Why is the President appointing convicted criminals like Eliot Abrams to policy positions at the White House?

Ari Fleischer: Russell, you asked that question last week.

Mokhiber: I did not ask that question last week.

Fleischer: You asked it about somebody else. I dispute the premise of your question.

Mokhiber: I have a second question.

Fleischer: I dispute the premise of your second question (laughter.)

As you can see, it’s an amusing read, and Fleischer and Mokhiber seem to enjoy (at least in print) the sparring. But the substantive point of all of this is that Bush doesn’t interact directly with the press, and Ari Fleischer just doesn’t give straight answers, and the press (except Helen Thomas) doesn’t complain.


He’s well to the left of me, but that doesn’t keep his cartoons from being hilarious and generally on the money. While I assume there are cheaper ways to view the strips, Tom Tomorrow alone justifies a good chunk of Salon’s subscription price or watching an ad.


I spent a few hours reading Eric Alterman’s What Liberal Media. As others have said, it’s good. Buy it and read it.

So far, it’s clear and convincing. (Of course, I started out with the belief that its fundamental premise is true). I hope to add some further commentary over the next week. But first, more dividend taxes (Monday).


I’ve developed what I fear may be an unhealthy addiction to tracking views of my blog, though I think it will pass with time. In any event, I see that I turn up on Google as the 9th most relevant hit for the search “bush’s tax consumption regressive”. That puts me one ahead of a Washington Monthly story by Robert McIntyre, but behind TAP, Slate, One Term President, and (yikes!)Free Republic.

Excitedly, I thought “what do Freepers think about this?” I hurriedly read the article and thought to myself, “hey, this is a pretty accurate discussion of the issue. Now I’ve got to link and endose Free Republic”.

Oops. is the Detroit Free Press, not Free Republic.


Dividend Taxes Part II: Options, Dilution, and Share Buyback Primer

For those familiar with dilution and share buybacks, much of this post will be old news (but do read the last paragraph), but I want to make sure that the readers understand the lingo before I start tossing it out.

Earlier, I mentioned that there are a few things companies can do with their profits. They can save them as cash, they can reinvest them (e.g., infrastructure or acquisitions), or they can give the money to the owners of the firm, shareholders.

There are actually two ways that firms can give money back to shareholders, the most obvious is to pay dividends in the way described in this post. The second way they can give money to shareholders is for the firm to buy back outstanding shares of the firm. A share buyback is just dilution working in reverse.

Dilution occurs when a corporation gives out options that are then exercised. An option gives the option-holders (usually employees) the right to buy shares in the company at some future time at a fixed price. Generally, when the market price rises above the option price, holders of options can realize a profit by exercising those options. Specifically, the profit is (Market Price – Option Price)*#Options. That’s great for option holders, but not so great for the other shareholders, because now their shares become a little bit less valuable. Go back to the example from my earlier post:

If there are 20 million shares of AB Tech outstanding, then that $4m has to be split $20 million ways, meaning each share represents the right to $4,000,000/20,000,000=$.20. AB Tech will pay this out as a dividend of 20 cents per share. If you own 10,000 shares of AB Tech then you get a check for $2,000.

If AB Tech option-holders exercise 4 million options prior to the dividend payment, the same $4m has to be split 24 million ways. This reduces the per-share payout to $4m/24m=$.167, a dividend of 16.7 cents per share. The shareholder who holds 10,000 shares now only gets $1667, not $2000, in dividend payments because his stake was diluted. To prevent dilution, companies often buyback outstanding shares, to keep the total number of shares outstanding roughly constant. Slate’s Daniel Gross is pretty good on this, here’s the relevant quote:

”Intel spends about $4 billion each year on its own shares, while it pays out just $530 million a year in dividends. Dell last fiscal year spent $3 billion on stock buybacks and paid no dividend.”

A final point on dilution. Suppose there were no options exercised, but AB Tech buys back 4 million shares. Then the same $4m gets split 16m ways, a dividend of 25 cents per share. This would increase the 10,000 share-holder’s payment from $2000 to $2500. Because each share is worth more when there are less of them, their price will go up. Shareholders can make a profit by selling those stocks at the higher price. So when AB Tech buys back outstanding shares, it is putting money into shareholders’ pockets. So at the end of the day, share buybacks work much like dividend payments: they take profits from the firm and give them to shareholders. Another way to think of buybacks is that they are dilution in reverse.

So how does a firm decide whether to put profits in shareholders’ pockets, and if so, whether to do it via share buybacks or dividend payments? (And why should we care?). A large part of the equation is tax treatment. Short term capital gains (gains realized from the price of the share increasing) are taxed at 20%. Dividends are taxed as personal income, at rate between 0 and 36%. Depending on the income-profile of shareholders and the extent to which their holdings are in retirement accounts, buybacks may impose less of a tax burden than dividends.

This is getting us close to the important point about dividend taxes: they 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. More to come.


I’m getting (relatively speaking) a lot of traffic from Alas A Blog today, who writes

Angry Bear is a brand-new economist-blog, and it looks like it’ll be worth reading. (One thing, Bear: please choose a different color for your outgoing links!).

Following the author’s (Ampersand) tip, I ended up on a two hour quest to optimize the color scheme. The process was made more difficult by my lack of knowledge of the details of html. I’ve also learned that the html I do know is now “deprecated”. Sounds bad doesn’t it?


A deprecated element or attribute is one that has been outdated by newer constructs. Deprecated elements are defined in the reference manual in appropriate locations, but are clearly marked as deprecated. Deprecated elements may become obsolete in future versions of HTML.

Yikes! Not just obsolete or outdated, deprecated!

I’ve used up my blog time for the day on playing with the blog template. More on dividend taxes over the weekend.