Abstract: There is much talk in Washington and the media about the impending expiration of the 2001 and 2003 tax relief. Those in favor of letting the tax cuts expire argue that to do otherwise would be merely to reward the rich at the expense of the lower-income population. Lost in these misguided accusations is the fact that higher dividend taxes—part of the tax increase currently scheduled for January 1, 2011—will not only hurt American companies, but penalize America’s senior citizens. Older people hold the most stock of any demographic group, and often rely heavily on dividends to supplement their Social Security income. Penalizing retirees would be one of the particu­larly bad outcomes of letting the Bush tax cuts expire. Time is running out and Congress should act now to make the tax relief permanent.

Unless Congress votes to extend them, the 2001 and 2003 tax relief packages will expire at the end of this year. Congress is currently focusing exclusively on whether to maintain lower income tax rates for all tax­payers or only those earning less than $250,000 a year. Lost in this narrow focus is the fate of other pro-growth tax policies that are vital to maintaining a strong and robust economy.

A lower tax rate on dividends is one of the most important pro-growth policies that will be lost unless Congress takes action. If Congress allows the tax rate on dividends to rise, the value of all stocks will fall sharply. The decline in stock value will harm all share­holders, but seniors will be hit hardest, as a dispropor­tionate number of retirees rely on stock dividends for a significant portion of their income.

To prevent a reduction on seniors’ income, Con­gress should make the current tax rate on divi­dends—15 percent—permanent.

Legislative Plan for Dividends

The budget resolution for 2010 calls for the tax rate on dividends to rise from 15 percent to 39.6 percent—a 164 percent increase—on January 1, 2011. That is the same rate as before 2003, when dividends were taxed as regular income.

The budget resolution is a guide that lays out Congress’s future fiscal plans. The policies con­tained in the resolution do not become law when Congress passes the resolution. Usually, Congress must pass legislation for policies contained in a res­olution to become law. Under current law, the tax rate on dividends will revert to its pre-2003 level, which means that Congress need simply do nothing for the remainder of 2010 and the tax rate on divi­dends will increase automatically. This makes it more likely that the rate will rise.

Further increasing the likelihood that the rate on dividends will increase are the lopsided pay-as-you-go (PAYGO) budget rules that are sup­posed to hold spending down, but in reality make tax hikes more probable.[1] Congress exempted many of the provisions in the 2001 and 2003 tax relief from PAYGO rules before passing the budget resolution. It will not have to “offset” those poli­cies by raising other taxes or reducing spending. However, Congress inexplicably left out divi­dends from the PAYGO exemptions. Members of Congress did not even make an exception for President Obama’s plan to set the dividend tax rate at 20 percent for families making more than $250,000 a year, another sign that this harmful tax hike was intentional.

If Congress chooses to enforce its PAYGO restric­tions in this case, Members of Congress that want to keep the dividends rate at its current 15 percent will need to find a way to reduce spending or increase other taxes to make up the revenue that the increased dividend tax rate was estimated to raise. The Treasury Department estimates that the reve­nue “lost” by keeping the rate at 15 percent instead of allowing it to spike to 39.6 percent is more than $233 billion over 10 years,[2] and $128 billion “lost” over 10 years under President Obama’s 20 percent. Of course, as with spending, Congress could choose to simply waive the PAYGO restriction in order to prevent this harmful tax hike.

Impact of Higher Dividend Taxes

The impending dividend tax increase will not be the only hike in the near future. In 2013, the 3.8 percent Medicare tax on investment income, which passed as part of the recent Patient Protection and Affordable Care Act, goes into effect. That will increase the total tax rate even further to 43.4 per­cent for families making $250,000 or more a year. In 2013, the tax rate on dividends will have almost tripled in the span of two years.

Higher taxes on dividends will reduce the value of all corporate stocks traded in U.S. markets, shrinking the wealth of anyone who owns stocks. Once again, it is particularly seniors who rely on stock holdings in retirement savings plans to sup­plement their Social Security benefits. These plans include 401(k)s, 403(b)s, IRAs, and self-directed state, local, and federal government employee retirement funds.

Dividend taxes decrease stock prices in two ways: (1) They reduce the after-tax value of the div­idends earned by stocks, and (2) they increase the cost of capital for businesses, thereby reducing future business profitability.

Stock Prices Fall

Using a widely accepted methodology to deter­mine the impact of raising the dividends tax rate to 39.6 percent, the value in current dollars of the yearly revenue raised by the tax increase is discounted by the latest available price-to-earning ratio of the Standard & Poor’s 500 to calculate the aggregate decline in stock prices.[3]

According to this calculation, the tax hike on dividends would cause stock prices to drop by more than $211 billion. The reduction in share values would happen almost immedi­ately at the beginning of 2011, or whenever Congress makes clear it will allow the rate to rise. Unlike a decline in stock prices due to market forces, which can turn around at any time, this government-induced reduction in wealth would be permanent unless Congress voted to reverse the tax hike in the future.

The $211 billion in lost wealth hits various sectors of shareholders differ­ently. The tax increase would reduce the share values of households the most, by more than $77 billion. Mutual funds are the next hardest-hit; their worth would decline by more than $43 billion. Table 1 shows the rest of the decline in share value by sector.[4]

Seniors Hit Hard by Tax Increase

The percentage of all stocks held in retirement savings plans is approximately 24 percent.[5] As such, one-fourth of the decline in stock prices would fall on stocks owned through these plans and the retirees that rely on them. This works out to $50 billion of unnecessarily lost value for cur­rent and future retirees because of the higher tax rate on dividends.

Seniors sell shares held in these funds after they retire to pay for their living expenses, including basics, such as housing, food, and medical care. When the stocks they sell decline in value, seniors have less money to pay their bills, and their budgets are squeezed tighter. Seniors also use dividend income to supplement their retirement income. Higher taxes on dividends means the amount of after-tax income they are accustomed to receiving from dividends to pay their bills will decline. Higher dividend taxes, in effect, penalize seniors, as stock prices are still struggling to recover from the finan­cial contagion—a particularly misguided step.

Lower Dividend Payouts, Riskier Investments

An even larger problem for seniors will arise when businesses that traditionally pay dividends stop paying them and choose to return value to their shareholders in other ways. If the rate on divi­dends rises to 39.6 percent, it will be almost 20 per­centage points higher than the tax rate on capital gains. The capital gains tax is currently 15 percent, but will increase to 20 percent with the expiration of the 2001 and 2003 tax relief.

As a recent Heritage Foundation paper ex­plained,[6] businesses will have an incentive to re­turn value to their shareholders by increasing the value of their shares rather than by paying out div­idends. The incentive to increase share value will be greater than the incentive to pay dividends be­cause shareholders will retain a larger portion of the capital gains from increased share prices than from the dividend they would have earned under the 15 percent rate. Businesses can increase share prices by investing retained earnings in the busi­ness to increase profitability. While seniors will benefit from increased share value in the long run (assuming the internal investment undertaken by the businesses is successful), in the near term se­niors will simply lose a source of income upon which they previously relied.

There is no guarantee that the investments that businesses undertake will be successful. In fact, the gap between the tax rate on capital gains and divi­dends would be an incentive for businesses to invest in riskier ventures that could pay high returns, but that also have a high likelihood of failure. Busi­nesses will make high-risk investments they would not have made if the rate on dividends and capital gains were equal. All shareholders, including seniors, will suffer lower share values when the fail rate of business investment inevitably increases and the returns that businesses tried to offer through internal investment instead of dividends never materialize.

Don’t Punish Seniors

Seniors rely heavily on dividends from corporate stocks and the sales of those stocks to supplement their retirement income, allowing them to maintain a higher standard of living. Rather than inflicting unnecessary harm on seniors, Congress should make the current 15 percent dividend tax perma­nent, and should waive its PAYGO oversight. In addition to helping seniors, this will keep the divi­dends tax rate equal to the capital gains tax rate and eliminate incentives for unnecessary risky ventures.

—Curtis S. Dubay is a Senior Analyst in Tax Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.