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The dividend distribution tax is levied by the government of India on publicly traded corporations that choose to distribute profit to investors in the form of dividends, or cash payments. The tax is controversial within the Indian business sector because investors worry about the changes in firms' behavior that may result from the incentive structure created by the tax policy. The decision to tax the corporation rather than the consumer, however, is largely a political one rather than one made for economic reasons — the economic theory concerning dividends and taxes shows that the two options have much the same effect on the economy.
Whenever an Indian company announces a distribution of dividends to shareholders, the government levies the dividend distribution tax, which comes out of the company's profits. The tax, as of 2010, was officially 15 percent of the total amount of the dividend payments. The effective tax rate, which is the amount that companies actually paid toward the dividend distribution tax, was close to 17 percent. Investors who receive dividends do not have to pay taxes on them.
The alternative to taxing dividends at the company level is to tax them at the individual level, as part of the income of the individual investor. This is the approach taken by many countries, including the United States. Each investor must file forms specifying his income from dividends.
From a theoretical standpoint, it does not matter whether the government taxes dividends at the corporate or the individual level. This is because the companies can anticipate the dividend distribution tax, so they decrease dividends accordingly. Thus, if investors and companies are taxed at equivalent rates in different countries, the actual transfer of funds is the same.
Companies could choose to avoid the tax by not distributing dividends. Instead, it could reinvest the funds in the firm, making market shares more valuable. Investors, however, sometimes see dividends as a sign of company strength, so the cessation of dividend payments, even if accompanied by an increase in share price, might discourage investment.
Ultimately, the decision to tax companies or individuals is a political one. A government could choose between the dividend distribution tax and individual taxes based on how it thinks each would be received by the public. It also depends on the structures already in place within the country. Taxing company distributions is much easier than relying on each individual to report his dividend income; however, if a strong individual tax system is already in place, then taxing dividends at the individual level might make more sense than creating a new bureaucracy to collect the dividend distribution tax.
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