dividends and capital gains to 15 percent. Nevertheless, effective taxes
on capital gains are still lower than on dividends since taxes on capital
gains are paid only when the asset is sold, not as the gain is accrued. The
advantage of this tax deferral is that the return from capital gains accu-
mulates at the higher before-tax rates rather than the after-tax rates as in
the case of dividends. I call the advantage of capital gains over dividend
income the “deferral benefit.”^4
For long-term investors the advantage of the deferral benefit can be
substantial. For example, take two stocks, one yielding 10 percent per
year in dividend income and the other yielding 10 percent solely in cap-
ital gains. Assume an individual is in a 30 percent taxable bracket, and
the capital gains and dividend tax rate is 15 percent. For an untaxed in-
vestor, both investments would yield identical 10 percent returns. But
the after-tax yield on the dividend-paying stock is 8.5 percent per year,
while, if the investor waits for 30 years before selling the capital-gains-
paying stock, the after-tax return is 9.41 percent per year. This is only 59
basis points less than the return of an untaxed investor.
Therefore, from a tax standpoint, there is still bias for firms to de-
liver capital gains as opposed to dividend income. This is unfortunate
since, as we shall note in Chapter 9, dividend-paying stocks generally
yield better before- and after-tax returns than non-dividend-paying
stocks. Dividends can be put on the same tax basis as capital gains if in-
vestors who reinvest their dividends back into the stock are allowed to
obtain a tax deferral on reinvested dividends until the stock is sold.
INFLATION AND THE CAPITAL GAINS TAX
In the United States, capital gains taxes are paid on the difference be-
tween the price of an asset when it is purchased (its nominal price) and
the value (price) of that asset when it is sold, with no adjustment made
for inflation. This nominally based tax system means that an asset that
appreciates by less than the rate of inflation—resulting in a loss of pur-
chasing power—will nevertheless be taxed upon sale.
Although the appreciation of stock prices generally compensates
investors for increases in the rate of inflation, especially in the long run,
a tax code based on nominalprices penalizes investors in an inflationary
environment. For a given real return, even a moderate inflation rate of 3
percent causes an investor with a five-year average holding period to
70 PART 1 The Verdict of History
(^4) It may be that firms that pay higher dividends have better incentives to provide shareholders with
higher total returns. This possibility is not explored in this chapter.