Senate plan:

• leaves 81 percent of dividend income subject to double taxation.
• does not address economic distortions.
• could backfare and not add to economic growth, setting back fundamental tax reform.

The Senate Finance Committee recently proposed a tax plan that would exclude the first $500 of dividend income, and 10 percent of any amount over $500, from federal personal income taxes.[1] The chairman of the Committee, Chuck Grassley (R-IA), then announced that "While not an absolute victory against double taxation, the proposal is reported to cover 86 percent of dividend receiving taxpayers and is a good step in the effort to eliminate economic distortions."[2] The Senator is overly optimistic.

IRS data, from 1999, show that about half of all returns with dividend income reported more than $550 in dividends. (See Table 1 and Table 1-A) In fact, more than 97 percent of all dividend income is reported on returns with more than $500 in dividend income. (See Table 2) Still, the main reason the Finance Committee's plan would do little to grow the economy is that it would leave about 81 percent of dividend income subject to double taxation. (See Table 3)

Supporters of dividend tax relief have argued that eliminating this double taxation would lower companies' cost of capital, thus increasing corporate investment and, therefore, additional jobs and higher incomes. This concept is somewhat technical, but its underlying logic is quite straightforward. The key is that corporate managers increase their investments because the cost of the funds (the capital) needed to invest in projects falls. Since their cost of capital would fall, some investment opportunities currently expected to lose money would instead be viewed as profitable.[3]

Another disadvantage of the Senate's plan is that it does nothing to change the unequal treatment of dividends and capital gains, thus leaving current economic distortions in place. Incidentally, the House Ways and Means Committee proposal creates uniform personal tax rates on both dividends and capital gains.[4] The House plan would reduce the personal income tax rate on long-term capital gains and dividends to 5 percent for filers in the 10 and 15 percent individual income tax brackets, and 15 percent for filers in the higher tax brackets.[5]

The Senate's plan would leave the majority of dividends subject to double taxation and would do virtually nothing to address economic distortions in the current tax system. For these reasons, the Senate's version of dividend tax relief would be ineffective and, perhaps, counterproductive to fundamental tax reform. By merely giving the appearance of lowering the double taxation of dividends, reaping the benefits actually doing so should not be expected.

Methodology Note
Dividend income reported to the IRS on the 1040 form includes dividends from direct holdings of equities, dividend distributions from mutual funds, and interest distributions from money market mutual funds. As a result, dividend income on the IRS Public Use File should be adjusted downward when estimating the amount of dividends from direct holdings of equities. Since precise distributional data is not available, dividend income was reduced proportionately for all taxpayers.

First, we reduced the amount of IRS dividend income to account for total distributions of mutual funds by using the most recently available data. These data were taken from the Bureau of Economic Analysis' (BEA) Survey of Current Business (from Table 1 - Comparison of Personal Income with AGI by Type of Income)[6], and were as follows:

Next, we used Investment Company Institute (ICI) data to account for the portion of mutual fund distributions that were money market interest distributions.[7] These data were as follows:

Using these ratios, we adjusted each record in the 1999 Statistics On Income (SOI) Public Use File. This adjustment was calculated as follows: