In a
bold move, President George W. Bush has proposed that the double
taxation of dividends be eliminated. Under his plan, businesses
would still pay tax on corporate income, but individual
stockholders would no longer pay a second tax on that income when
it is distributed as dividends.
The
President is addressing a very serious problem. The Internal
Revenue Code punishes investment by taxing dividend income twice.
Discarding one of these layers of taxation will encourage more
investment by reducing the tax bias against capital formation. This
important reform could single-handedly increase the nation's supply
of capital (e.g., machinery, tools, and equipment) by nearly 1
percent.
This will lead to more jobs and higher living standards.
Because of improved economic performance,
all Americans will gain if the double tax on dividends is
eliminated. Even Federal Reserve Board Chairman Alan Greenspan, who
rarely has a kind word to say about tax relief proposals, testified
recently that "elimination of the double taxation of dividends will
be helpful to everybody." Greenspan specifically praised the
President's proposal, stating, "This particular program will be of
net benefit to virtually everybody in the economy over the long
run, and that is one of the reasons I strongly support it."
Ending the double taxation of dividends
will increase economic growth and boost U.S. competitiveness. These
are tangible benefits, but they should not overshadow the important
goal of creating a simple and fair tax code. Taxing income only
once is a key feature of all tax reform plans, and President Bush's
dividend proposal is a necessary step toward fundamental tax
reform.
Double Taxation is Bad for America
Few
tax policies are more self-destructive than the double taxation of
corporate profit. Double taxation punishes an
activity--investment--that is unambiguously good for the nation. It
encourages taxpayers to put today ahead of tomorrow. It retards
economic growth by lowering investment and promotes excessive debt.
Combined with other misguided tax policies, it hinders America's
competitiveness in the global economy.
Bias Against
Capital Formation
Taxes discourage the activity that is taxed. This is one
of the reasons, for instance, that politicians impose so-called sin
taxes. By this standard, investing in corporate equity must be a
terrible transgression. With dividend income taxed at both the
corporate and individual levels (see Chart 1), the effective tax
rate can easily exceed 60 percent (or even 70 percent for investors
living in high-tax states).
These punitive tax rates discourage
investment, much as harsh sin taxes affect the consumption of
targeted products. By so doing, they reduce the nation's stock of
productive capital by causing some taxpayers to forgo investment
and instead use the money for consumption. In addition, these high
tax rates misallocate capital by leading taxpayers to shift their
investment patterns in ways that are less economically efficient.
The net effect of these decisions is lower wages and slower
growth.
Burdening
Taxpayers
Double taxation of dividends imposes a specific hardship
on certain classes of taxpayers. The elderly receive almost half of
all dividends, and the double tax imposes an average annual tax
burden of $936 on nearly 10 million seniors. Many of these seniors rely
on dividends for retirement income, yet their efforts to create a
more comfortable existence are undermined by the double tax.
Shareholders, of course, bear the direct
burden of double taxation. The most obvious burden is that their
investment income is taxed twice. Adding insult to injury, double
taxation also reduces their investment options. The share of
companies paying dividends has dropped by 50 percent in the past 40
years--a decline that is almost surely due in part to the double
tax. Investors seeking to balance their portfolios between "growth
stocks" and "income stocks" must therefore pay a price premium for
shares that still pay dividends--meaning that the rate of return on
these stocks is lower. Dividend yields, for instance, have fallen
from more than 4 percent in the 1980s to less than 2 percent
today.
Encouraging
Debt
Subjecting dividend income to an extra layer of tax
creates a bias for borrowing since equity investment is taxed twice
while debt-financed investment is taxed once. This tax bias against
equity is so significant that corporate managers have little choice
but to over-utilize corporate debt. This may be their best choice,
given the tax code's perversity, but it comes at a cost. Companies
incur large amounts of debt, making them vulnerable to an economic
downturn during which revenues fall while interest costs do
not.
A
neutral tax code would encourage companies to restructure their
finances and improve their balance sheets, thereby reducing
bankruptcies. It is impossible to know, of course, whether this
policy would have prevented any of the recent high-profile
bankruptcies. However, it is very safe to say that this reform, if
enacted, would prompt a significant shift from debt to equity. This
would reduce bankruptcies since the tax code would no longer
encourage corporations to incur excessive debt.
Lowering Wage
Growth
Workers are paid based on production, and there are only
two ways to increase their output. One option is to work longer
hours, but this is generally not desirable since it deprives
workers of time with their families and other leisure activities.
The other option is to increase productivity. If workers are able
to increase their hourly output, they can simultaneously preserve
their leisure time and become more valuable to their employers.
This
is why investment is so important. Workers become more productive
when they have better tools, equipment, and technology. Yet the
double tax on dividends penalizes capital investment. As a result,
this means less investment, which translates into lower wages for
American workers.
Just Part of the
Problem
Imposing two layers of tax on dividends is a bad policy,
but it is only one example of the tax code's bias against saving
and investment. If investors die with "too much" wealth,
accumulated dividend income is subject to the death tax. Most
perverse of all, this income can also be hit by the capital gains
tax. Stocks rise in value because of a market expectation of higher
future income, and this increase in share price is subject to
capital gains taxation. This means essentially that dividends can
be taxed once before they even materialize.
These multiple layers of taxation are bad,
but tax policies compound the damage by forcing companies to
overstate profits. Depreciation, for instance, treats a portion of
new investment as if it were taxable income. Foreign tax rules
require companies to pay tax on income that was already taxed by a
foreign country. And the alternative minimum tax compels businesses
to pretend that some costs do not exist, artificially inflating
taxable income.
Under existing law, cash dividends are
taxable as ordinary income. Some companies offer dividend
reinvestment plans, under which stockholders can automatically use
their dividends to purchase more stock without paying brokerage
fees. However, in this case, both the value of the dividends and
any brokerage fees paid by the company count as taxable income.
BENEFITS OF REFORM
Boosting the
Economy and Increasing Wages
The President's proposal will substantially reduce the tax
burden on productive behavior. The effective tax rate on dividend
income will drop--in some cases by more than 50 percent. This will
help the economy grow faster, but higher national income is just
one of the many benefits. Eliminating the double tax on dividends
will also remove a significant distortion in the tax code, creating
an environment in which decisions are more likely to be guided by
economic considerations instead of tax-minimization goals.
There are several reasons why the economy
will benefit if lawmakers shift to a tax code that taxes dividend
income only once. These reasons include:
- Increasing
investment
The effective tax rate on corporate investment could fall
by as much as one-third, dropping from 32.2 percent to 21.7
percent. This translates into a lower tax burden on investment
income. According to the Council of Economic Advisers (CEA), "By
lowering the tax cost of corporate investment, a dividend exclusion
could also lower the economy-wide average effective tax rate on
capital income by as much as one-quarter (from 19.8 percent to 14.8
percent) and improve the overall incentive to save and invest." The CEA
also estimates that the cost of capital investments in equipment
would be reduced by more than 10 percent and that the tax burden
for equity investment in structures would be cut by more than
one-third.
- More efficient
use of capital
Ending the double tax on dividends would create a level
playing field, removing tax preferences for non-corporate
investment and owner-occupied housing. In other words, capital
would be allocated in ways that maximize growth instead of ways
that minimize tax. A 1992 U.S. Treasury
Department study found that, even in the absence of increased
investment, eliminating double taxation would eventually raise
economic output in the United States by about 0.5 percent of
consumption--equal to about $36 billion each year.
- Attracting
global capital
In a competitive world economy, nations with pro-growth
policies attract money from investors in other nations. With about
$2 trillion changing hands every day in global capital markets,
this is an increasingly important reason to eliminate the double
tax on corporate profits.
More
investment and better investment are the benefits of dividend tax
reform. Both would promote higher wages in the long run. The
proposal would also enhance near-term economic growth. Eliminating
double taxation would encourage higher levels of corporate
investment and capital accumulation, resulting in greater
productivity increases and, therefore, higher wages for
workers.
Academic
Evidence
Many economists have long argued that the double taxation
of dividends reduces the after-tax return on capital in the
nation's economy and thus discourages corporate investment. This
reduced corporate investment, such as purchases of new business
equipment and machinery, weakens economic growth. Consequently,
these economists would argue that eliminating this double taxation
would spur corporate investment and improve the economy's long-term
growth.
While empirical evidence does support such
claims, economists have struggled with many issues surrounding the
taxation of dividends. For example, given the tax-disadvantage of
receiving dividends, economists have striven to explain why firms
pay dividends at all. Furthermore, the lack of significant changes
to U.S. dividend tax policy through most of the last century has
made empirical studies problematic.
As a
result, a large portion of the professional literature has focused
on explaining why dividends are paid. Aside from the obvious
reason--that investors want cash despite the tax burden--two of the
more common theories found in the literature are the "free cash
flow" and "signaling" hypotheses. On balance, a fair amount of
empirical evidence supports each hypothesis.
The
free cash flow hypothesis states that shareholders want dividends
because distributing this leftover cash prevents managers from
having "too much" cash. Theoretically, having extra cash allows
managers to fund projects that are not in the best interest of the
shareholders. The signaling hypothesis states that managers are
distributing cash to shareholders to "signal" that the firm has
good long-term prospects. The idea is that a firm's ability to pay
out cash on an ongoing basis represents a sound financial
structure.
Empirical evidence for other aspects of
dividend tax policy, such as which investors seek dividends and the
economic effects of double taxation, is smaller in volume and less
conclusive. Still, some empirical evidence does suggest that
eliminating the double taxation of dividends would lower the cost
of capital and, in turn, increase investment and economic growth.
Since the United States is one of only three countries in the
30-member Organization for Economic Cooperation and Development
(OECD) without some form of protection from the double taxation of
dividends, much of the empirical evidence examines the experiences
of other countries.
In
1987, New Zealand and Australia implemented a dividend "imputation
credit" mechanism to eliminate the double tax on dividends. This
method, which has the effect of adding back the corporate layer of
tax to the dividend received by the shareholder, was found to
increase capital investment in both countries. Furthermore, the imputation
credit employed in Australia was found to offset the
investment-dampening effects of a capital gains tax increase.
In a
1984 paper, James Poterba and Lawrence Summers tested several
competing hypotheses regarding the economic effects of dividend
taxation, using data from the United Kingdom. Unlike the United States,
the United Kingdom has experienced several dividend tax reforms
since the 1950s, making empirical testing more straightforward. The
authors found that the double taxation of dividends in the United
Kingdom did lower corporate investment and worsen distortions in
the capital markets.
One
of the few recent U.S. tax reforms that lends itself to this type
of empirical study is the Tax Reform Act of 1986 (TRA86). A 1991
paper by Serge Nadeau and Robert Strauss notes that TRA86
significantly reduced the tax advantage of retained earnings over
dividends. The authors' model
estimated that this tax reform reduced the cost of equity capital
by about 30 percent. A 1992 study found that TRA86 lowered the cost
of capital and increased investment. Recently, Heritage
Foundation economists simulated the dividend tax reform bill
introduced by Representative Christopher Cox (R-CA) and estimated
that ending the double tax on dividends would lead to higher
investment and economic growth.
Making America More
Competitive
Ending the double taxation of dividends would boost U.S.
competitiveness. According to a Cato Institute survey, only three
of the world's 30 developed nations--America, Switzerland, and
Ireland--double tax corporate income. And since Switzerland and
Ireland have lower corporate tax rates, this means that America has
one of the most punitive and anti-growth dividend tax policies in
the industrialized world. Indeed, only Japan has a higher top tax
rate on dividends. (See Chart 2.)
This
is an embarrassment--and it clearly puts America in a
disadvantageous position. About one-fourth of our competitors do
not impose any double taxation on dividends, and almost all of the
rest provide at least partial protection from double taxation.
According to the Council of Economic Advisers:
all countries in the G-7 but the United
States provide at least some relief from the double tax on
dividends. Italy provides full relief.... Germany has a 50 percent
dividend exclusion, and the United Kingdom has a preferential rate
on dividends plus a system in which shareholders receive partial
credit for taxes paid at the corporate level.
By
ending the double taxation of dividends, President Bush hopes to
significantly improve America's ranking in this critical measure of
global competition. Being next-to-last is not a smart policy in a
competitive world economy. Because the United States also has a
high corporate tax rate, eliminating the double tax will not put
America in first place, but it would put America in the top tier of
nations. This means more jobs for American workers and more capital
for American companies.
Regrettably, the President's proposal does
not eliminate the double tax on foreigners who invest in U.S.
companies. Currently, nonresident aliens are subject to a 30
percent withholding (i.e., pre-paid) tax on dividends, and that
second layer of tax will remain in effect. This discriminatory
treatment is misguided. Ending the double taxation of dividends
paid to foreigners will significantly increase the amount of
foreign capital invested in the U.S. economy.
Building Wealth
and Boosting Retirement Income
Repealing the dividend tax would help investors at any
income level to build wealth and improve their retirement income.
While it would especially help those who directly invest in stocks
that pay regular dividends, the predicted overall rise in the stock
market would even assist those who put their funds in a
tax-advantaged 401(k) or similar retirement plan.
Experts estimate that simply passing
President Bush's proposed repeal of the double tax on stock
dividends could lift the entire stock market by as much as 10
percent.
This would replace about 45 percent of the average stock portfolio
loss in 2002. However, the legislation would have an even greater
effect simply because it would encourage more companies to pay
regular dividends--and investing in stocks that pay dividends can
be a good strategy for building a retirement nest egg.
Today, dividends are somewhat out of
fashion, but historically, they have played a key role in the
valuation of a stock. Currently, only about 35 percent of publicly
traded companies pay dividends, while over 70 percent paid regular
dividends in 1960. As recently as 1982, about
60 percent of companies listed on the New York Stock Exchange,
NASDAQ, and American Stock Exchange paid dividends. Today, that
proportion is less than 40 percent. Larger companies are more
likely to pay dividends than smaller ones.
Similarly, dividend yields have dropped.
In 2002, the average dividend yield at the year-end value of
S&P 500 stock was 1.83 percent. Since 1936, the average
dividend yield for that index has been 4 percent. At the market low
in October 2002, the yield was 2.02 percent. At the low point of
the 1974 bear market, the dividend yield was 5.77 percent, and the
market low for the 1982 bear market was a dividend yield of 6.62
percent.
This
decline in both the number of companies that pay dividends and the
reduced dividend yield has forced investors to rely on market
appreciation for most of their profits. Dividends accounted for
about 16 percent of average annual returns on the S&P 500
during the 1990s; over the past 75 years, they accounted for an
average of 43 percent of the market's total returns. Clearly,
encouraging more companies to pay dividends would reduce the risk
of equity investments while also providing a stable source of
retirement income.
Investing in companies that pay dividends
can be profitable. Some experts contend that companies that pay
dividends actually outperform those that do not pay dividends. In
1996, James O'Shaughnessy pointed out in his book What Works on
Wall Street that investing in carefully selected large
capitalization stocks that pay dividends can actually result in
higher profits than the average return for large capital stocks.
Recently, Motley Fool, an on-line
investment adviser, tested this premise by selecting nine
dividend-paying stocks with annual yields greater than 4.5 percent.
They excluded utilities, bank stocks, and real estate investment
trusts. Motley Fool's staff invested $1,000 in each of nine
dividend-paying stocks on June 13, 2001, and held them until
December 4, 2002. During that time, the S&P 500 stock index
lost about a quarter of its value. However, the nine stocks lost an
average of only 8.5 percent, while paying dividends equal to 7.4
percent of the purchase price, and were worth a total of $8,907.94
at the end of the experiment.
Before retirement, an investor can use
dividends to accumulate a company's stock through a "dividend
reinvestment plan" (DRIP). Under this plan, an investor allows the
company to take the dividends that would have been paid and use
them to buy additional shares of the company's stock. Over the
years, these plans act like compound interest as dividends from
shares purchased through the DRIP allow the purchase of even
greater amounts of the company's stock. In almost all cases, the
investor also avoids paying any brokerage fees for the
transaction.
In
the past, retirees who could afford to have any investments often
owned utility stocks because of their regular cash dividends.
Today, companies in the utility, financial, and material sectors,
along with larger energy companies, are most likely to offer higher
dividend yields, according to Sam Stovall, chief investment
strategist for Standard and Poor's. At the same time, looking
only at yields, which are usually expressed as a percentage of the
average price of the stock in question, can be misleading. If a
stock price is falling sharply and the dividend remains the same,
the yield will seem very large. For that reason, marginal stocks
with dividends may look like a real value even though the company
is clearly in trouble--and could suspend payment of its dividend. Investors
should consider both the dividend yield and the underlying
financial condition of the company before investing.
Regardless of income level, an investor
will benefit from the repeal of the double tax on dividends. Those
who invest through 401(k) or similar retirement plans, because of
the overall rise in the market resulting from passage of the tax
change, will see their portfolios increase by about 10 percent.
Those who invest through other plans will receive the direct
benefit of tax-exempt dividends. In addition, more companies will
choose to pay dividends regularly. Investment in the stocks of
sound, well-managed dividend payers will reduce investors' exposure
to market risk and increase their ability to build wealth for their
retirements and other purposes.
Boosting Stock
Values
The 84 million Americans who own equities have suffered
steep losses over the past few years. The Dow Jones Industrial
Average fell 7.1 percent from December 2000 to December 2001 and
another 16.8 percent from December 2001 to December 2002. During
these two years, the Dow dropped just over 22 percent. One good
way to reverse this trend would be to eliminate the double tax on
dividends.
Many
economists have noted that eliminating this double tax is likely to
boost the stock market, helping people recover much or even all of
their recent losses--even if the stockholders, such as holders of
individual retirement accounts (IRAs), do not currently pay taxes
on dividends. This means that Americans who assume they will have
to delay their retirement because of their shrinking IRAs or
pension funds could see their retirement plans become real again.
The following is a sample of what these economists are saying:
- Lynn Reaser, an economist with Banc of
America Capital Management, predicts that eliminating the double
tax on dividends could boost the stock market by as much as 10
percent.
- White House economist R. Glenn Hubbard
estimates that repealing the double tax could increase equity
values by up to 20 percent.
- The Joint Economic Committee reviewed the
evidence and found that stock prices would increase between 6
percent and 13 percent.
- Dr. John Rutledge estimates that the
S&P 900 would rise in value by 8.5 percent and that investors
would enjoy an increase of almost $800 billion in their net
worth.
Some
observers focus on the all-important psychology of Wall Street. "A
cut in dividend taxes...could help to lift some of the gloom on
Wall Street," says Greg Valliere at Schwab Washington Research. "It
would be quite positive, quite quickly for the stock market." A 10
percent increase in stock values due to the dividend tax repeal
would enable the average stockholder to recoup 45 percent of the
typical portfolio decline during 2002. A 20 percent recovery in
values would mean that the average portfolio would recover 75
percent of the 2002 loss and just over 57 percent of the losses
from the past two years.
In
other words, eliminating the double taxation of dividends is one of
the most positive and immediate actions that Congress and the
President could take to restore investor confidence and portfolio
value.
Improving
Corporate Governance
The Bush proposal will mean faster growth, stronger
retirement, more competitiveness, and higher stock prices, but the
plan promises several other benefits. One of those benefits is a
better set of incentives for proper company management and wiser
investment strategy. There has been much publicity about the recent
spate of high-profile corporate bankruptcies. In many of these
cases, company executives made poor decisions--some of which
crossed the line into illegal and/or immoral choices--that have
been properly criticized. But what was not adequately discussed is
how double taxation actually promotes bad business behavior.
Many
corporate critics, for instance, have denounced companies for
taking on too much debt while failing to acknowledge the role of
the tax code. Under current tax law, companies are encouraged to
use debt, not equity, to finance investments because dividends are
taxed twice and interest on corporate bonds is taxed only once. If
the Bush plan is approved, this bias disappears and companies will
have a strong incentive to strengthen their balance sheets. The
1992 U.S. Treasury Department study, for instance, estimates that
the leverage ratio (the ratio of debts to assets) would fall by as
much as 7 percent. This would mean fewer
bankruptcies.
Another common complaint is that companies
overstate earnings. This certainly is a valid criticism, but it is
also appropriate to investigate how the tax code encourages this
behavior by creating a perverse incentive for companies to hoard
earnings. The double tax on the earnings kept by companies (capital
gains) is lower than the double tax on the earnings they distribute
to investors (dividends). The President's plan would end this
anti-dividend bias, giving companies an incentive to attract
investors by offering dividends instead of promising capital
gains.
The
other side of this coin is that eliminating the double tax on
dividends will have a positive impact on investor attitudes.
Because of the heavier tax on dividends (distributed earnings),
investors are more likely to seek stocks that pay capital gains. If
this anti-dividend bias disappears, companies will be more likely
to attract investors by offering periodic payments (dividends)
instead of promising capital gains. This will improve corporate
governance, since firms no longer will feel as much pressure to
boost share prices by making unwarranted claims about future
revenue. Investors will then be more likely to judge companies by
the dividends paid to shareholders.
This
does not mean that dividend reform will stop all companies from
overstating revenues and understating costs. Some companies will
still incur too much debt even if the double tax is eliminated and
debt and equity are treated equally. Corporate executives, like
people in other walks of life, are far from perfect. However,
eliminating the double tax will end the perverse incentive to incur
excessive debt and/or give overly optimistic (or even dishonest)
projections of future revenue streams.
Is there a better way to eliminate
double taxation?
If
taxing income more than once hinders economic growth, the obvious
answer is to eliminate double taxation. But there are three ways to
achieve this goal. The President's approach--eliminating the second
layer of tax at the individual level--is the preferred method, but
the other approaches are theoretically similar and would generate
the same economic benefits.
- The individual
side
This is the approach sought by the Bush Administration.
Dividend income would be subject to the corporate income tax, but
individual taxpayers would no longer have to pay a second layer of
tax on this income. Excluding all dividends from the personal
income tax is the simplest way to achieve this goal. The
President's proposal largely utilizes this method but, regrettably,
is not quite this straightforward because of concerns that existing
tax credits might allow some dividend income to escape tax at the
corporate level.
- The corporate
side
Allowing companies to deduct dividend payments is another
way to end double taxation of dividends. Firms would subtract
dividend payments from taxable income, effectively ending the tax
at the corporate level. Individual taxpayers, however, would
continue to pay tax on that income. It is worth noting that the tax
code uses this method to protect bondholders from double taxation.
(Companies currently can deduct interest payments.)
- The combination
method
Finally, lawmakers could eliminate the double tax by
mixing the previous two options. Simply stated, dividend income
would still be taxed at both the corporate and individual levels,
but at lower rates. The easiest way to implement this policy is to
allow companies to deduct 50 percent of dividend payments and to
require individuals to pay tax on 50 percent of their dividend
payments (much as individuals are allowed to exclude a portion of
their capital gains from taxation).
While all three options achieve the same
goal, the President's approach has certain advantages: Three are
good economic policy, and two address political concerns. From the
standpoint of economic policy, eliminating the tax at the
individual level:
- Would be
consistent with fundamental tax reform
All tax reform plans are based on the commonsense notion
that economic activity should be taxed only once (and presumably at
the lowest possible rate). The most prominent of the tax reform
proposals is the flat tax, and dividend income is taxed at the
business level under this approach. President Bush's plan therefore
is an important step toward fundamental tax reform.
- Would be simple
to implement
Major companies often have more than one million
shareholders. If dividend income is to be taxed only once, it is
administratively much easier to collect the tax using one tax
return--the corporation's--instead of requiring the Internal
Revenue Service (IRS) to track millions of shareholders.
- Would enhance
individual privacy
Taxing dividend income at the corporate level
theoretically means that individuals would no longer have to tell
the government about their private financial investments. The
President's plan does not achieve this important goal, but it is a
substantial step in the right direction.
From
a political standpoint, eliminating the tax at the individual level
represents:
- A smaller tax
cut
Thanks to individual retirement accounts and investments
by nonprofit institutions, a significant portion of dividend income
already is shielded from double taxation. As a result, fixing
double taxation at the individual level requires a smaller tax cut
than would be required if the double tax was eliminated at the
corporate level. This is important because politicians generally
are reluctant to reduce the amount of money flowing to
Washington.
- Less
demagoguery
Class-warfare ideologues criticize the President for
"giving a tax cut to his rich friends," but this demagoguery is
modest compared to what would have happened if the Administration
had tried to end the double tax at the corporate level. Critics
would have accused the President of favoritism to corporations at a
time when high-profile corporate governance scandals have created
an impression that big business is either venal or
incompetent.
Responding to Myths
President Bush's tax reform
plan--particularly the proposed elimination of the double taxation
of dividends--was instantly criticized for benefiting "the wealthy"
and lacking "economic stimulus." According to Senator Joseph
Lieberman (D-CT), "President Bush hasn't proposed a stimulus plan,
instead, he has put forward an irresponsible, ineffective,
ideologically driven wish list."
These arguments, however, are firmly
grounded in myth, not reality. Specifically:
MYTH 1: Dividend tax relief benefits only
"the wealthy."
Reality: The benefits from eliminating the
double taxation of dividends come from at least two sources:
economic growth and stock price increases. Roughly 84 million
Americans now own equities, either directly or in tax-deferred
retirement plans. While it is true that people with stocks in
retirement plans will not receive direct tax relief, to say they
will not benefit is misleading.
People who own equities through retirement
plans own the same equities that other investors own directly. In
other words, a share of Microsoft stock owned in an IRA is the same
as a share of Microsoft owned directly. Therefore, any increase in
the stock price resulting from dividend tax reform accrues to
individuals owning the stock both directly and through retirement
plans. Additionally, IRS data show that 70 percent of
dividend-receiving taxpayers earn less than $55,000 in wage
income.
Nevertheless, improving overall economic growth is still the most
important reason to eliminate the double taxation of dividends.
The double taxation of dividends freezes
capital and unnecessarily reduces the return on capital, making it
more costly for corporate managers to invest. As a result, managers
invest in fewer projects that, in turn, result in fewer jobs.
Eliminating this double taxation will lead to increased investment,
greater productivity, higher output, more jobs, and more money in
people's pockets.
MYTH 2: State and local governments will
be hurt if dividends are taxed only once.
Reality: There are two issues for state
and local governments. First, lawmakers from these governments fear
that they will have a harder time borrowing money because municipal
bonds, which are not subject to double taxation, will no longer be
as attractive to investors if dividends are taxed only once.
Second, these politicians fear that state and local tax revenues
will decline because federal taxable income (which often is the
starting point for state and local tax returns) will be
smaller.
Both
of these concerns are misplaced. Repealing the dividend tax should
not affect the market for tax-exempt bonds. Investors buy bonds and
stocks for different reasons. While bonds have a market price that
is based on the relation of their coupon interest rate to the
prevailing interest rate at the time they are bought and sold as
modified by the investment rating of their issuer (which measures
the risk that the bond will not be repaid), this valuation is very
different from that of a stock. According to Mary Miller, Assistant
Director of T. Rowe Price's Fixed Income Division,
Investors often buy bonds to reduce the
overall risk of their portfolio. It's then a question of whether to
buy taxable or tax-exempt bonds. We entered the year [2003] with
tax-exempt bonds attractively priced compared to taxable bonds. We
don't think tax-exempt bonds will be substantially affected by this
proposal.
The
Council of Economic Advisers reached the same conclusion:
Municipal bond yields are based on the
fundamental economic factors of inflation and risk. The proposed
Bush tax cut does not change the treatment of tax-exempts.
Therefore, it will not impact yields in any material way.
State and local lawmakers are also
misguided to worry about potential revenue loss. Assuming states
take no action, it is true that the 100 percent dividend exclusion
will reduce state revenues by about $4 billion per year, but this
looks at only one-half of the equation. If the economy grows
faster--which is a certainty if the double tax on dividends is
repealed--the reduction in revenues caused by removing dividends
from the tax base is more than offset by higher state revenues due
to the greater growth resulting from the package.
According to the Council of Economic
Advisers, each 1 percent increase in gross domestic product (GDP)
boosts income tax and sales tax revenue for state governments by
slightly more than 1 percent--roughly $6 billion per year. Since
the CEA projects that the President's tax package will increase GDP
growth by 0.4 percent in 2003 and 1.1 percent in 2004, this means
that state income and sales tax revenue will increase by more than
$6 billion. The Treasury Department
conducted a wider analysis, looking at the impact of the dividend
tax on all forms of tax revenue, including both state and local
government, and found that receipts would climb by about $20
billion annually.
In
other words, a stronger national economy will increase the tax base
for states and result in higher tax collections. The CEA even
presented two real-world examples of this phenomenon:
- In 1982 when GDP growth turned negative
(-1.6 percent), state and local governments had deficits of $2.3
billion, compared with surpluses of $7.5 billion in the previous
year.
- In 1998, GDP grew at a rate of 4.8
percent, and state and local governments had surpluses of $40.7
billion, with revenues increasing by 6.2 percent from the previous
year.
MYTH 3: Repealing the double tax on stock
dividends would result in lower investments in retirement plans
such as 401(k) plans.
Reality: Current law allows workers to
protect their savings from the double taxation on interest by using
401(k) accounts or IRAs. This has led some in the industry to fear
that these accounts would become less attractive if the double tax
on dividends is eliminated. A study by T. Rowe Price, a fund
management company, shows that this should not be the case. The study
shows that even after the repeal of the dividend tax, a worker
would accumulate more in either a 401(k) retirement plan or a Roth
IRA than
they would by investing the same amount of money in a plan that did
not have tax-neutral features.
The
study assumed that $1,000 in gross income was invested for 20 years
in an account that would pay 8.5 percent annually, including 2.5
percentage points in dividend income. Funds invested in the 401(k)
plan were made in pre-tax dollars upon which no taxes had been
paid. On the other hand, investments in the Roth IRA and
non-tax-advantaged plan were made after income taxes were paid on
the $1,000, which reduced the initial amount being invested to $694
in each case.
After 20 years, the $1,000 invested in the
401(k) plan was worth $4,661, with $1,459 in taxes owed upon
withdrawal for an after-tax value of $3,232. Meanwhile, the $694 in
after-tax income that was invested in the Roth IRA was also valued
at $3,232, upon which no taxes were owed. The amount available from
both tax-advantaged accounts was almost 20 percent more than from
the taxable account even if the double tax on dividends is assumed
to have been repealed. In that case, the $694 in after-tax income
grew to $2,757, which after paying income taxes of $145 leaves
$2,612, or $620 less than was available from the tax-advantaged
accounts.
Thus, even though repealing the dividend
tax increases the total amount available from investing $1,000 of
gross income by 16 percent, that return is still significantly
lower than it would be from investing the same amount in a
tax-advantaged 401(k) plan or Roth IRA. There is no reason to
assume that changing the dividend tax would reduce the amount
invested in either 401(k) plans or Roth IRAs. This is especially
true if the employer matched all or part of an employee's
contributions to the 401(k) plan. On the other hand, the holders of
those tax-advantaged accounts would also benefit from the predicted
10 percent increase in overall stock values that would result from
the dividend tax repeal in addition to the value of any dividends
from companies that had not previously paid them.
MYTH 4: Corporations and "the rich" pay
too little in taxes.
Reality: First, corporations do not pay
taxes; people pay taxes. Whether they are wealthy investors or
hourly wage earners, individuals bear the burden of corporate
taxes--some directly, some indirectly. For example, when corporate
taxes are levied, less money is left to pay shareholders and
workers, and more money is needed to pay taxes. Corporate taxes,
therefore, translate into higher prices, lower wages, and lower
returns on investment.
Additionally, an entire industry now
exists specifically to help corporate managers lower these taxes.
Spending money solely to lower the tax burden and to comply with
the onerous tax code, as well as to pay the taxes themselves, means
that resources are wasted and that workers, consumers, and
investors keep less.
This
same misguided reasoning is used when critics complain that "the
rich" get away with paying too little in taxes. First, calling
someone wealthy is subjective. IRS data show that, as of 2000, tax
returns with adjusted gross income (AGI) of $92,144 are in the top
10 percent of all income totals. However, this AGI total
alone obscures a great deal of information. For example, a single
person living in a Houston suburb and earning $92,144 is probably
better off than a family of four living on Long Island and earning
$92,144.
Even if it is agreed that those taxpayers
in the top 10 percent are "the rich," the same data show that this
group pays just under 70 percent of all income taxes. In fact, the
top 1 percent pays nearly 40 percent of all income taxes despite
earning about 20 percent of all income. Regardless of a person's
income level, having more money to save, invest, and spend benefits
all of society. Punishing success by taking more of every dollar
earned away from individuals hurts everyone.
For example, an aspiring young
professional with $28,000 in taxable income has a top marginal tax
rate of 15 percent, which means that the worker keeps $85 of the
last $100 earned. If this person gets a raise
and ends up with a taxable income of $29,000, this individual would
now move into the 27 percent bracket and keep only $73 of the last
$100 earned, a difference of $12.
Since the 27 percent tax bracket starts at
taxable income of $28,400, this reduction in take-home pay applies
to the last $600 earned, a difference of $72. Looked at
differently, this individual is working for no wages for about five
hours.
Since the marginal rates continue to rise with income, this
situation worsens as more money is earned. Not only does this rate
structure discourage work, but it also encourages behavior to lower
taxable income, meaning the government ends up with less despite
raising tax rates.
This example applies to a broad spectrum
of American workers. A 1992 U.S. Treasury Department report found a
great deal of income mobility in the U.S. The study divided people
into five equal groups (quintiles) classified by income. The
results showed that that between 1978 and 1988, about 86 percent of
those in the bottom quintile moved to a higher quintile, and 35
percent of those in the top quintile moved to a lower quintile. More
recent studies have found similar results, which means that anyone,
regardless of current income, could soon find himself or herself
among "the rich."
Conclusion
President Bush's plan to eliminate the
double tax on dividends is a bold and visionary step. His proposal
will make our nation stronger and improve the living standards of
all Americans. It will make the United States more competitive in
the global economy and eliminate a bias against saving and
investment. This will mean a significant improvement in the
economy's performance.
Ending the double taxation of dividends
also is an inherent and necessary component of fundamental tax
reform. All proposals to create a simple and fair tax code--such as
the flat tax--are based on the notion that income should be taxed
only once. President Bush's proposal should therefore be seen as an
important step toward a tax system based on sound economics and
good tax policy.
Daniel J.
Mitchell, Ph.D., is McKenna Senior Fellow in Political
Economy in the Thomas A. Roe Institute for Economic Policy Studies,
Norbert J. Michel is a
Policy Analyst in the Center for Data Analysis, and David C. John is
Research Fellow in Social Security and Financial Institutions in
the Thomas A. Roe Institute for Economic Policy Studies at The
Heritage Foundation.