======Classical Tax System======
The Classical Tax System is a framework where corporate profits are taxed twice. First, the company pays [[corporate income tax]] on its earnings. Then, when these after-tax profits are distributed to shareholders as [[dividends]], the shareholders must pay [[personal income tax]] on that income. This is the infamous '[[double taxation]]' you hear about—the taxman gets two bites of the same apple! For example, if a company earns €100 and pays a 25% corporate tax, it is left with €75. If it pays this €75 out as a dividend, the shareholder who receives it then pays their own income tax on that €75. This system is straightforward but creates a significant tax hurdle between a company's pre-tax profit and the final cash in an investor's pocket. The United States, for instance, operates a classical system, which heavily influences how American companies think about distributing cash to their owners.
===== How It Works: A Tale of Two Taxes =====
The core concept is simple but its effect is powerful. Understanding the mechanics helps you see why companies might prefer certain actions, like buying back shares, overpaying dividends.
==== A Simple Example ====
Let’s follow €1,000 of profit as it journeys from a company to an investor's wallet under a classical system.
  - 1. **Company Earns Profit:** ACME Corp earns a profit of €1,000.
  - 2. **Corporate Tax (First Bite):** The government levies a corporate income tax of, say, 21%.
  * Tax paid by ACME: €1,000 x 21% = €210
  * Profit remaining: €1,000 - €210 = €790
  - 3. **Dividend Distribution:** The board of ACME decides to distribute all the remaining profit to its sole shareholder, Jane.
  * Dividend received by Jane: €790
  - 4. **Personal Income Tax (Second Bite):** Jane is in a tax bracket where her dividend income is taxed at 20%.
  * Tax paid by Jane: €790 x 20% = €158
  - 5. **The Final Tally:** Jane's net cash from the original €1,000 profit is €790 - €158 = €632.
In this scenario, the total tax paid on that €1,000 of corporate profit is €210 (corporate) + €158 (personal) = €368. The //effective total tax rate// is a whopping 36.8%!
===== The Value Investor's Perspective =====
For a value investor, the tax system isn't just a boring detail; it's a critical part of the landscape that shapes corporate behavior and, ultimately, your long-term returns.
==== Impact on Dividends vs. Retained Earnings ====
The classical system creates a clear tax-based incentive for companies to retain earnings rather than pay them out as dividends. If a company retains its after-tax profit, that second layer of tax is deferred indefinitely. If the company can reinvest those retained earnings at a high [[return on invested capital]] (ROIC), it creates a powerful compounding effect for shareholders.
This is central to the philosophy of investors like [[Warren Buffett]], who have historically preferred companies that are masters of [[capital allocation]]. Why take a dividend and pay immediate tax on it if the company's management can reinvest that same money for you at a 15% annual return, tax-deferred?
This tax structure also makes [[share buybacks]] an attractive alternative to dividends. By repurchasing shares, a company returns cash to shareholders by increasing the value of their remaining shares. This gain is only taxed as a [[capital gains]] tax when the investor sells their shares, which is often at a lower rate and at a time of the investor's choosing.
==== Does It Favor Debt Over Equity? ====
An interesting side-effect is that the classical system can make debt financing more attractive than equity financing. Why? Because the interest a company pays on its debt is typically a tax-deductible expense. Dividend payments, however, are paid from after-tax profits. This "tax shield" for debt can influence a company's capital structure, a key element for investors to analyze.
===== Classical System vs. Other Systems =====
Not every