Why Pay Dividends?

The Ides of March is come, but not yet passed. Wait a minute, you say. Isn't March 15 the Ides, that is, the middle of the month? Yes and no. You see, under the old Roman calendar before Julius Caesar's reforms (for which he hired a subcontractor), all the months, including February, had 30 days, and you had the Saturnalia, which was five days not counted in the calendar, making the year 360 days long, not 365 (the Romans liked numbers that could be divided evenly by 12, making for easier mental calculations . . . you try doing the math: CCCLXV/XII = uh, Magister, can I get back to you on that?). This put the Spring Equinox and thus the Roman New Year — the Ides of March — on what we now call March 21, but that the Romans called March 15.

Why bring this up? It shows how easily not knowing some critical information can lead to something "everybody knows" being wrong. True, the whole calendar issue is something of a "so what?" but what about the almost dogmatic faith that most people and virtually all economists have in the belief that the only way to finance new capital formation is to cut consumption and accumulate savings?

As you know, in Capital Homesteading we advocate making dividends tax deductible at the corporate level, but fully taxable as regular income at the personal level, unless used to make debt service payments on capital assets put into a tax deferred Capital Homestead Account. If, at the same time, we raise the corporate tax rate and make it possible for companies to float new equity to finance expansion and growth, corporations would be encouraged (in theory, at least) to pay out all earnings as dividends to shareholders. Assuming that corporate equity is broadly owned, and people use the dividends first to pay for their shares and then for consumption instead of reinvestment, Say's Law of Markets would be restored and the business cycle of "boom and bust" eliminated naturally, without government control of the economy or manipulation of the currency.

Still, old habits and assumptions die hard. Earlier today we got the question, "Wouldn't paying out all profits in dividends ostensibly destabilize a company, especially in a contracting market?"

The quick answer is, "No."

The longer answer is that paying out all profits and financing operations and expansion by issuing new equity shares would not destabilize a company. It would, on the contrary, generate the effective demand essential to creating or expanding a market for the company's product. In accordance with Say's Law of Markets (ignoring Keynes's oversimplification), we don't purchase what others produce with "money," but with what we ourselves produce.

Dividends are an owner's share of profits — that is, the result of his or her production of marketable goods and services by means of his or her labor and capital. If profits are not paid out but reinvested in the company, overall effective demand declines and all companies produce less. It's a vicious circle. If you don't consume, then goods produced by others pile up, and they have no income to purchase what you produce. If no one buys your product(s), you have no income, you don't consume, and the cycle keeps going downward.

Some people maintain that you must retain earnings in the company in order to finance new capital instead of paying profits out as dividends. On the contrary —

First, retained earnings are never expended for new capital. The only regular charge against retained earnings is dividends. When cash is accumulated, it is an asset, not retained earnings; the company has invested in cash: liquidity. Cash by itself is not normally a good investment, so most companies "park" their cash in commercial paper, the stock market, and so on. They don't keep it in sacks in the office. Savings always equals in investment, whether in the form of productive or financial capital.

Second, most new capital is financed not directly by retained earnings (as we have seen), or even with accumulated cash, but by issuing new equity or taking on debt. If debt, the company draws bills of exchange or mortgages and discounts (sells) them to other merchants or a bank which, assuming the drawer's credit is good, accepts it at the present value of the note less a "risk premium" for self insurance. This is why bills of exchange are known as "merchant's" or "trade acceptances" if used directly as money in commerce, and "banker's acceptances" if discounted or rediscounted at a commercial or central bank, which issues a promissory note and uses it to back token coinage, banknotes, or demand deposits.

If the company uses equity financing, the company floats new shares, and the ultimate purchaser pays for the shares out of his or her own resources, either by exchanging other assets, such as accumulated savings, or by drawing a bill (margin purchase).

Third, the chief use of assets already owned by the company in finance (the chief use in operations is to produce marketable goods and services, of course), of which retained earnings represent an ownership stake, is as collateral to secure borrowings for new capital, not for the direct purchase of new capital.

Finally, the right side of the accounting equation, Assets = Liabilities + Owners Equity (where Owners Equity = Retained Earnings + Contributed Capital) is a statement of ownership, i.e., who owns or has a claim on what is on the left side of the equation, "Assets." Profits — retained earnings — belong by natural right to the shareholders of the corporation. Withholding them without their explicit consent deprives them of the exercise of their property — their rights — without just cause or due process.

Well, Hail, Caesar, isn't that a little complicated?

Hail, yes — but you ought to see how Keynes thought the system operated, achieving its reductio ad absurdum in "Modern Monetary Theory" (a.k.a., "chartalism") that has resulted in a devastating global depression, gargantuan national indebtedness, and a virtual takeover by governments of every economy on earth.

If you think it's worthwhile trying to alert the powers-that-be to the need to correct the problem — and how to correct it — you might want to show up at the annual Rally at the Federal Reserve in Washington, DC, on Friday, April 20, 2012 at 11:30 am to 1:30 pm. Togas optional.

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