The House of Representatives and the Senate recently passed, respectively, the Tax Relief Extension Reconciliation Act of 2005 (H.R. 4297) and the Tax Relief Act of 2005 (S. 2020). The two bills represent the tax reconciliation legislation of the two chambers, enacted under the guidelines of their respective budget resolutions.

Despite this common parentage, the two bills differ significantly on how they would interact with the economy, thus raising the tax policy stakes in the conference committee. The Senate bill is filled with targeted tax cuts and tax subsidies designed to change specific economic behaviors. Little if anything in the bill would affect the rate of economic growth. However, the House bill would take a substantial step toward a stronger economy by extending the lower tax rates on capital gains and dividend income for two years.

The lower tax rates are currently set to expire at the end of 2008. These tax rates help to reduce the tax code's bias against income that is saved and invested and have helped to fuel the current robust economic expansion. The conference committee on these two bills should adopt the House approach on capital gains and dividends.

Temporary Tax Cuts on Investment

The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 temporarily reduced the tax rates on capital gains and dividend income.[1] Proponents of the tax rate cuts argued that reducing these rates would bolster the economy by encouraging investment in promising enterprises and by making dividend payments to stockholders more attractive to companies. Dividend payouts allow companies to reward their shareholders in a way other than focusing just on increasing the stock price.

Recent data show that the tax cut proponents' assessment of JGTRRA was right.[2] Regrettably, Congress has not made these tax cuts permanent and risks reversing these positive developments. Because businesses make investment decisions based in part on the taxes that they will face over many years, it is likely that the prospect of tax increases after 2008 is already discouraging some of the more entrepreneurial and risky undertakings. In the jargon of chief financial officers, the "hurdle rate" (the return on investment required to permit an undertaking to go forward) will rise to levels that make some projects untenable.

Businesses are watching now to see whether Congress will make permanent the first of the major economic growth components of the 2001 and 2003 tax acts, extend them, or allow them to expire.[3] Allowing the low tax rates on investment to expire would signal businesses of all sizes that the other major pro-growth elements of the Bush tax plan will expire, undermining the current economic expansion. Thus, Congress should make the tax reductions permanent, which would:

Bolster economic growth by reducing the cost of capital,

Increase the distribution of dividend payments, and

Make the tax code more stable and predictable-key elements of good tax law.

The 2003 Tax Bill Provisions

With business investment slumping in 2001, 2002, and early 2003, JGTRRA focused on reducing the cost of capital to make investment more attractive.[4] The resulting lower capital costs allowed businesses to invest in slightly riskier projects and retire machines and factories early.

Before these changes, the tax code did not differentiate between dividend income and other types of income. Dividend income could be taxed at a rate as high as 38.6 percent, the highest marginal rate in the tax code. The average marginal tax rate for dividends was 28 percent, almost twice the average marginal rate of capital gains of 15 percent. Taxpayers above the 15 percent marginal tax bracket paid a capital gains tax rate of 20 percent. Those below the 15 percent bracket paid a tax rate of 10 percent.[5]

JGTRRA reduced dividend taxation by treating dividend income like capital gains income. Both dividend and capital gains income are investment income, which means that they have already been taxed once as regular income. JGTRRA sought to reduce the burden of double taxation, which reduces the incentive to invest.

Because of this tax bias against dividends, stockholders preferred compensation in the form of retained earnings (capital gains) rather than distributed earnings (dividends), and companies shifted toward capital gains and stock appreciation and away from dividend payments. The difference in taxation changed the price of capital for companies and made dividend payments more expensive than capital gains.[6] As a result, many companies focused too much on their stock prices, leading to scandals and fraud such as those involving Enron and Arthur Andersen.

Members of Congress wanted to give companies another option to reward shareholders other than increases in stock prices. Taxing capital gains and dividend income at the same rate gives investors a strong incentive to seek reliable companies that would pay out earnings in cash instead of speculative stock gains.

Dividend Payments After JGTRRA

Dividend payments increased after JGTRRA was enacted in the second quarter of 2003. Some companies responded by increasing their dividend payout, and 19 other companies instituted a dividend payment for the first time. Overall, almost 9 percent more companies paid out dividends after the 2003 tax cut than before the tax cut.[7]

dividends payments to taxpayers increased from an average of $410 in the second quarter of 2003 to $518 in the third quarter of 2005-an increase of 24 percent.[8] The overall payout of dividends in 2005 was over 36.5 percent higher than the payout before the 2003 tax cut.[9] Dividend income increased by a similar margin after the 2003 cut, from $750 to $1,000.[10] This is particularly important for individuals age 62 and over and close to retirement because dividend payments are an important source of their incomes.

A number of studies point to the dramatic increase in dividend payouts following the 2003 act. Jennifer Blouin, Jana Ready, and Douglas Shackelford documented significant increases in dividends following passage of JGTRRA.[11] Others have noted the strong growth in equity values that stemmed from enhancing the income stream from stock ownership.[12] Table 1 in the Appendix shows the distribution of dividend income by state as reported on federal tax returns for 2003.

Capital Gains After JGTRRA

Chart 1 shows that the number of Americans reporting capital gains income is clearly increasing. In 1993, 14.5 million Americans claimed capital gains income. By 2003, the number had grown to 21.9 million Americans-a 51 percent increase. More important, the percent of all taxpayers reporting capital gains income increased from 12.6 percent in 1993 to 16.8 percent in 2003.

The 2003 tax cuts probably contributed to a strong stock market in 2003, which helped to increase tax revenues on capital gains. The stock market experienced the second largest percentage increase in the past decade: The broad-market indexes experienced double-digit annual growth rates after the 1997 capital gains tax cut and the 2003 capital gains tax cut.[13] This increase in equity capital helped to finance new businesses and has led to the increased job growth since the summer of 2003.

In addition to the economic effects, taxpayers claimed an average of $12,283 in capital gains income in 2003. As Table 2 shows, this average varies significantly from state to state. The five states with the highest averages are Nevada ($28,582); Wyoming ($22,639); Connecticut ($18,466); Florida ($17,118); and Massachusetts ($17,024). However, the unmistakable feature of Table 2 is the surprising size of the average in every state. Clearly, gains from taxable capital investments constitute a substantial portion of income for the average taxpayer.

It is not surprising, then, that reductions in capital gains tax rates enjoy widespread support. In state after state, about one-fifth of all tax returns contain taxable capital gains. Even in the states with the lowest percentage of returns showing taxable gains, the percentage is remarkably high: Mississippi ranks 50th with 10 percent of returns containing capital gains; West Virginia (ranked 49th) shows 11 percent of its taxpayers with taxable gains. The five states with the highest percentages are Connecticut (23.4 percent); New Jersey (22.3 percent); Montana (22.0 percent); Colorado (21.4 percent); and South Dakota (21.1 percent). (See Table 2 in the Appendix.)

Conclusion

Reducing dividend and capital gains taxes succeeded in supporting stronger economic growth and making dividend payments more popular to businesses. After the tax cut, many companies such as Microsoft began offering dividend payments or increased their dividend payouts. In addition, extending these tax rates or making them permanent would reinforce a central element of good economic policy: predictable and stable tax law.

Business investment has grown in every quarter since the 2003 tax cut, in part due to the reduced cost of capital. The Congressional Budget Office estimates that the current average taxation of dividends is 12 percent, but it will become 28 percent if the JGTRRA provisions are allowed to expire.[14]

In the end, however, it is not Congress's job to manage the economy or to assume a "leading role," as old-style European socialists call it, in directing economic development. Congress's role is to set tax policy that raises needed revenues for government while interfering as little as possible with private-sector decision making, which really does matter to economic growth.

Extending the lower tax rates on dividend and capital gains income would go a long way toward fulfilling Congress's basic tax policy responsibilities.

Rea S. Hederman, Jr., is Manager of Operations and a Senior Policy Analyst in the Center for Data Analysis, and William W. Beach is Director of the Center for Data Analysis, at The Heritage Foundation. The authors gratefully acknowledge the contributions of J. Scott Moody, who worked on an early version of this paper while serving as a Senior Policy Analyst in the Center for Data Analysis.

Appendix