Rationality is something that economists often like to assume when trying to apply complicated mathematical jargon to economic concepts.  Take away that assumption and the problem often breaks down into something less solvable, but perhaps more true to life.  One question which often comes up is the question of whether or not the stock market is over-valued.  Are investors being irrational?  Measures such as dividend yield and P/E ratio which have traditionally been used to value companies are going out of favor, as dividend payments dwindle and profitless dotcom companies still exist.

     A notable Wharton finance professor, Jeremy Siegel, recently attempted to bring the issue of falling dividends back into the public mind by publishing an article in the Wall Street Journal.  He argued that indeed it makes sense that companies refuse to pay dividends.  Dividends suffer from double taxation.  That is, earned income from the firm is taxed once when the firm earns revenue and again when it is distributed to shareholders.  It makes more sense in many cases to reinvest the money in the firm than to distribute it to shareholders.  Siegel cites Warren Buffet as a case and point, as the CEO of Berkshire Hathaway adamantly claims that the firm will never pay a dividend.  Suggesting that dividends used to provide a tangible measure of a firms well-being, Siegel proposes that the current lack of dividend payments creates a transparency problem.  Without dividends to show financial health, it becomes harder to spot bad apples, such as in the case of Enron.

     The capital gains tax has always been a point of contention.  Market purists argue that it restricts the flow of capital, and it does.  People cut investment activity because of the tax, which makes buying and selling become less profitable.  This in turn slows the rapid allocation of society's resources to its most productive means.  Capital gains are also largely time insensitive.  Even though there are some tax advantages to realizing a capital gain after 12 months of ownership rather than prior to this date, the methodology is still slanted.  Take the case where someone buys a stock in 1970 for $10 a share.  They then sell the stock in 2002 for $40.  Because of inflation, the individual is actually losing purchasing power in the deal.  At the same time however, he/she still has to pay tax on a $30 gain, in essence enhancing the size of the loss of wealth.

     Proponents of dividend and capital gain taxation maintain that the tax is good for the economy.  Both taxes are strongly progressive, supporting income equality in the economy.  Most people in the lower 3 quintiles of the income distribution, that is those below the top 40%, don't have significant capital holdings besides their home and as a result bear less of these taxes.  Others argue that the capital gains tax is especially important because it helps to control the volatility in financial markets.  By cutting down the gains from buying and selling, it provides disincentives to phenomena such as day trading.

      Given the current tax structure, one certainly can't argue that investors are irrational in not demanding a dividend or even in supporting firms such as Amazon which continue to build debt.  That said, it is still difficult to say that the government has to do anything to correct this problem.  Dividend and capital gain taxation are sticky political as well as economic issues, and for one thing, the government is certainly not in a fiscal position to reasonably address them in the near future.  For another, the US stock market has been remarkably successful over the past decade despite these taxes and controlling what might be seen as market exuberance is not necessarily a bad thing.  Regardless, debate over double taxation and the capital gains tax will continue.