US company profits: tax and bend Ladies and gentlemen, who would not agree that it is wrong for American billionaires to pay less tax than their hairdressers? Cheering. Therefore, as your president, I have decided that it is time to lower the value of each and every one of your stock portfolios. Stunned silence. No politician would dare utter those words. But by proposing to raise taxes on dividends in his 2013 budget, President Barack Obama's plan would theoretically do just that: lower after-tax equity free cash flows equal lower stock prices, other things being equal. Which is why, from a shareholder perspective, Wednesday's announcement that the Obama administration also wants to lower the maximum rate of income tax for corporations is financially inconsistent with the dividend idea. Of course, it may not be if the overall tax take rises because of parallel eliminations of deductions. The latter would merely amplify the potential hit to equity valuations. Consider a hypothetical company making $5bn a year in revenues, growing at 10 per cent per annum with an operating margin of 40 per cent. Assume capital expenditures chew up a 10th of revenues each year and the corporate tax rate is 35 per cent. With a terminal growth rate of 3 per cent and a cost of capital of 8 per cent, the company is worth about $24bn. Lower the tax rate to 28 per cent, as Mr Obama proposes for some companies, and the same company is worth $28bn. Taxing dividends more would have the opposite effect. In theory, at least, shareholders should be indifferent to a tax grab on their dividends or on profits before pay-outs. What does matter, however, is the relative rate of tax on dividends versus on capital gains. So if dividends are taxed through the roof relative to the proceeds on asset sales, investors will demand that companies cease paying them. Instead, they can sell a small number of shares in the market (at a premium equal to the foregone dividends). Shareholders hate tax - but constantly adapting to distortions is annoying too.