Change the tax code to favor dividends. (From Where I Sit).

Amid all the recent attention attracted by corporate malfeasance, there is no shortage of valid explanations: unbridled personal greed, a general degradation in business ethics, lax boards of directors and complicit corporate lawyers. Certainly, executives found guilty of unlawful behavior must be brought to justice.

Behind the punishable crimes, however, is one overlooked and relatively new phenomenon--the effect of institutional investors on management priorities. Institutional investors, such as pension funds and mutual funds, now own half of all the publicly traded stock in the United States. That's an increase from just 10 percent 40 years ago, reflecting the wealth of the aging baby boomers.

Although institutions are investing the money of millions of Americans, individual investors have relatively little influence. In virtually all cases, the individual investor's s voice is unheard by corporations, except as represented by the fund managers. And the legitimate motivation of a fund manager is to maximize the value of fund. Because U.S. tax law discourages the payment of dividends, the primary method of improving fund value is through stock price appreciation.

One method of improving a company's stock price is to have the company acquired. Such a sale almost always generates an acquisition premium, usually about 40 percent. So, institutional shareholders typically vote against takeover defenses, like staggered boards or so-called "poison pills." And, if a company is not attractive in total, then institutional investors often promote break-up value, the value of the company's pieces that, if sold separately, may be greater than the whole.

The need to constantly generate smooth earnings and support stock price levels has become all-pervasive. Failure to meet quarterly earnings expectations can be disastrous for stock prices and fatal to CEO tenure (which is growing increasingly shorter).

Institutional shareholders also support the leveraging of balance sheets (the new art of financial engineering) so that available capital can be deployed for the purpose of expanding the business, making acquisitions or buying back company stock to increase the earnings per share of the remaining outstanding shares. It's worth noting that in 1973, 27 percent of corporate bonds in the Lehman Brothers Aggregate Bond Index were rated AAA and only 9 percent were rated BBB. By 2001, a mere 8 percent were rated AAA and 34 percent were rated BBB. Today, there are few "under-leveraged" balance sheets.

Given the nation's demographics and investment patterns, institutional investors' influence will continue to grow. And their understandable focus will continue to be on near-term stock price appreciation. How, then, can the systemic incentives be altered to produce a better societal result? One positive step would be the elimination of double taxation on dividends.

Presently, U.S. tax law imposes income tax on corporate profits; if those profits are paid out as dividends, they are taxed a second time as ordinary income to individual shareholders, creating a combined state and federal tax rate of 65 percent. Eliminating double taxation by making dividends a tax-deductible business expense could help change behavior. (Sen. Bob Bennett, R-Utah, made that point on the Senate floor on July 26 when he said, "Nothing government does affects corporate activity more than the Tax Code. That's were we ought to look for serious cultural changes.")

The two ways companies obtain capital are through borrowings or through equity investments. Presently, interest payments on borrowings are a tax-deductible business expense, but dividends, or payments on equity attracted, are not. Consequently, two-thirds of U.S. public companies pay no dividends, and the yield on stocks that do is only about 1.5 percent, down from about 5 percent a quarter-century ago. Today, dividends are considered "tax inefficient."

If U.S. tax law would treat dividends like interest, there would be a compelling incentive for more companies to pay dividends. And. for most companies, dividends need not fluctuate--even in weak-performing quarters. That stream of dividends would form a more concrete basis for valuing a company's stock (computing the present value of the dividend stream), and stock prices would react as companies increased, or decreased, or when the future prospects seemed strong (or weak). Now, institutional investors are forced to estimate a stock's worth based entirely on perceived earnings potential and assumptions about what others will be willing to pay.

If stock valuations were linked more directly to dividend yield, managements would have greater incentive to focus on longer-term growth rather than on smooth quarter-to-quarter earnings. The more predictable basis for valuing stocks would likely modify the kind of exuberance seen in the 1990s, when stocks were valued, even by sophisticated institutional investors, employing the "greater-fool" theory--that is, no matter how indefensibly high a stock was priced, it may well have been worth it so long as someone was willing to pay still more!

If stocks prices related to an expected dividend stream, individual investors would benefit from somewhat lower price volatility. Management attention could focus more on the long term, which encourages increased spending on R&D and capital investment. Those investments create new jobs and improve the global competitiveness of U.S. firms. Although institutional fund managers would continue to function as sophisticated financial monitors, the incentive for earnings management would be moderated, and perhaps the temptation to push accounting rules to (and beyond) the limit would be similarly reduced.

The distribution of significant dividends to shareholders would generate individual income tax revenue that could help offset federal taxes lost if corporations could expense dividends. U.S. tax revenues would also benefit if corporations maintained a dividend flow, taxable to individual shareholders, in years when corporate taxable income is weak. The tax change would encourage equity financing (present law favors debt financing) and might reduce corporate bankruptcies.

Finally, creating new jobs, goods and services should ultimately generate yet additional tax revenue. Hopefully, Congress's calculations of the revenue effect will dynamically factor all the potential benefits. If, in the final analysis, this action actually reduced net tax revenues, corporate tax rates could be modestly adjusted to provide the offset.

This simple tax code change would create a basis for more rationally valuing stocks, and would focus the attention of institutional shareholders and companies on the longer term. It might also yield a "dividend of virtue" in investor and corporate behavior that could only be good for the economy and for every American.

Louis E. Lataif is Dean of the School of Management at Boston University. He can be reached at [e-mail]. To contribute a perspective, email [e-mail] or [e-mail].