In his 2 years in office, US President George W. Bush has dealt aggressively with issues important to oil and gas companies. The energy plan his administration produced early in its tenure was comprehensive and bold—too bold, as things turned out, for Congress. In terms of the potential effect on oil and gas companies, however, Bush's most sweeping proposal didn't appear in his controversial energy policy. It didn't appear until this month and isn't specifically about energy. It's the proposal to end double taxation of corporate earnings distributed to stockholders as dividends.
Like the energy policy, which encouraged oil and gas leasing in part of the Arctic National Wildlife Refuge, the dividend idea faces rough air in Congress. Anti-ANWR turbulence helped stymie comprehensive energy legislation last year. In similar fashion, antibusiness politics will shake up any effort to correct a financial distortion embedded for decades in the tax code. If Bush's measure somehow survives and becomes law, however, the oil and gas business—like most others—will profoundly change.
Imagine an oil and gas business in which companies concentrate more than they do now on generating profits from operations and less than they do now on gobbling one another up. That's the kind of change toward which the right kind of tax treatment of corporate profits might steer the industry.
Tax bias
Tax law now imposes a bias favoring debt at the expense of equity finance. It makes interest deductible from company revenue in calculations of corporate income, which it taxes at the company level as well as the shareholder level if distributed as dividends.
Michael Porter, a thought leader in business strategy, argued in a Jan. 14 Financial Times article that eliminating the bias against dividends "would markedly improve company strategies by better aligning them with true economic fundamentals." Porter, author of a highly regarded 1980 book on strategy, is Bishop William Lawrence university professor at Harvard Business School.
Because double taxation discourages payout of dividends, Porter says of business in general, share values depend too heavily on investor expectations about growth. Rather than pay dividends, company managers, their compensation tied to share-price performance, tend to reinvest earnings in expansion and acquisition, supplementing them with borrowed funds. The compulsion to grow at all cost makes market share a managerial priority, which erodes industry profitability, and leads to questionable diversification and uneconomic acquisitions. It results in poor profit performance and creates opportunities to manipulate reported earnings.
Ending the double taxation of corporate earnings, Porter asserts, would make it possible for companies to provide attractive returns to investors without depending on the uncertain appreciation of stock prices. With double taxation gone, capital would flow to companies best able to earn profits and most willing to share them with investors. There would be less pressure to fortify market share by buying competitors and less inducement to grow recklessly through mergers and acquisitions. Growth would still be important but only within a framework of profitability and acceptable risk.
Porter wasn't writing specifically about the oil and gas business. But he might well have been. Mergers and acquisitions have been reshaping the industry since the 1980s—not uniformly for the better. Double taxation of corporate earnings isn't the only force behind this trend. But it's an undeniably strong factor. Without it, oil and gas companies at least would have a diminished urge to mate and a sharpened focus on bringing energy profitably to market.
Improving strategy
To achieve full economic benefit of ending double taxation of dividends, Porter advises, the government should apply relief at the corporate rather than individual level. That way, the change would most strongly influence managerial decisions and, in Porter's view, best enhance long-term corporate productivity by improving strategy.
Of course, anything that appeared to benefit corporations instead of individuals would stiffen political resistance to change. The Bush administration seems to be targeting individuals, pointing out in a fact sheet that, "for every dollar of profit a company could pay out in dividends, as little as 40¢ can actually reach shareholders."
At this point, any change would be a step in the right direction. If nothing else, debate over the Bush proposal can provide a healthy reminder that corporations don't pay taxes; people do.