Double Taxation is Bad for America

Tax policies that punish savings and investment are counterproductive. Every economic theory (including Marxism) teaches that capital formation is necessary to raise wages and stimulate long-term economic growth.

Policymakers who want to boost savings should eliminate the anti-savings provisions in the federal tax code, preferably by replacing the code with a simple and fair flat tax that would end multiple taxation of capital. To the extent that such fundamental reform is not immediately possible, Congress can and should take a number of incremental steps to alleviate the bias against savings and move toward a flat and fair tax system:

• Make individual retirement accounts (IRAs) universal so that all taxpayers could save as much as they want without being taxed twice;
• End the double taxation of non-retirement savings;
• Repeal the 1993 tax increase on Social Security benefits; and
• Eliminate tax penalties on dividends, estates, capital gains, and other forms of capital.

Double Taxation and the Elderly

While certain taxes, such as the death tax and double tax on dividends, are not explicitly designed to hit seniors, the elderly bear a disproportionate share of the burden. Seniors have higher levels of saving and investment than younger Americans. In part, this is simply because they have had the opportunity to accumulate capital during their working years. But there are also reasons why the elderly, in particular, save--including the need for economic security and the desire to provide a nest egg for their families.

These goals, however, are sabotaged by the tax code, which imposes numerous forms of double taxation. Three of the most onerous are:

• The death tax
  The death tax is imposed when taxpayers' assets are above a specified value at the time of their death. Given that assets are typically purchased with after-tax income, the death tax clearly qualifies as double taxation. Indeed, because many financial assets in a taxpayer's estate may already have been subjected to other layers of taxes, the death tax often is a form of triple, or even quadruple, taxation.
• The tax on Social Security benefits
  This is one form of double taxation that specifically targets the elderly. Thanks to the 1993 tax increase, single retirees with incomes above $34,000 and couples with incomes over $44,000 now must pay tax on 85 percent of their Social Security benefits. Since only the so-called employer share of the tax is paid in pre-tax dollars--meaning only 50 percent of Social Security taxes is deductible--it is double taxation to tax more than 50 percent of benefits.
• The dividend tax
  Returns on corporate investments are subject to double taxation. First, the income is hit by the corporate income tax (and the United States has the fourth highest rate in the industrialized world). Then, when profits are distributed as dividends, the same income is taxed a second time at the individual level via the personal income tax.

Tax Relief for the Elderly

Fixing these flaws in the tax code is good for economic growth, good for American competitiveness, and good for the elderly. The White House has announced that "almost half of all savings from the dividend exclusion under the President's plan would go to taxpayers 65 and older," and that "the average tax savings for the 9.8 million seniors receiving dividends would be $936." 1

A Heritage Foundation analysis of the data confirms that the elderly would be major beneficiaries of dividend tax reform. Among post-retirement age taxpayers who receive dividends, the median taxpayer (single, married, and combined) receives dividend income of $2,406, with an after-tax income of $35,544. The median single taxpayer in this group has a lower after-tax income of $21,844 and a higher dividend income of $3,184. The median married taxpayer in this group has an after-tax income of $44,921 and a dividend income of just under $2,000.

The death tax is scheduled to disappear in 2010. That is the good news. The bad news is that it reappears in 2011. This tax reform must be made permanent if it is to boost economic growth and rescue older Americans from this pernicious form of double taxation. Last but not least, the double tax on Social Security benefits currently is part of the tax code, and it does not appear that this black mark in the system will be erased anytime soon.

Good Tax Policy will Boost Economy and Increase Wages

Removing or reducing all forms of double taxation will lead to more jobs and increased wages, boosting the economy and raising living standards.

Additional Benefits of the President's Tax Plan

A few other features of the Bush tax plan also are worth discussing--particularly with regard to the positive consequences of eliminating the double tax on dividends. Specifically, the President's plan would:

• Make America more competitive
  The Bush plan would boost U.S. competitiveness abroad. According to a Cato Institute survey, only three of the world's 30 developed nations--America, Switzerland, and Ireland--impose a double tax on corporate income. Given that Switzerland and Ireland have much lower corporate tax rates, this means that America may have the most punitive and anti-growth dividend tax in the industrialized world.

  This is an embarrassment, and it clearly puts America in a disadvantageous position. About one-fourth of the nation's competitors impose no double taxation on dividends, while almost all the rest have policies that provide at least partial protection from double taxation. Only Japan--which is hardly a role model--has a top dividend tax rate above America's.

• Help Americans build wealth and save for retirement
  Another benefit of eliminating the double tax on dividends is an increase in wealth. The value of a financial asset is determined by how much after-tax income an investment will generate over time. Removing the second tax on dividends would increase that future income flow and therefore help the stock market. Financial experts say the stock market could expand by about 10 percent under the Bush plan, boosting national wealth by nearly $1 trillion--welcome news for workers who have watched their IRAs and 401(k) accounts shrink.
• Improve corporate governance
  The Bush plan holds promise for several additional benefits. Under current tax law, for instance, companies are encouraged to use debt, not equity, to finance investments. Why? Because dividends are taxed twice and interest on corporate bonds is taxed only once. If the President's plan is approved, this bias disappears and companies will have a strong incentive to strengthen their balance sheets. This would mean fewer bankruptcies.

  The current tax code also creates a perverse incentive for companies to hoard earnings. Why? Because the double tax on the earnings they keep (capital gains) is lower than the double tax on the earnings they distribute (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. This would improve corporate governance, since firms no longer would feel as much pressure to boost share prices by making unwarranted claims about future revenue. Instead, investors would judge a company by the amount of hard cash it pays its shareholders.

Conclusion

The Internal Revenue Code imposes two layers of tax on corporate income. Companies must pay a 35 percent tax on profits. If the remaining after-tax income is then distributed to shareholders, it is subject to another layer of tax since individuals must include dividends in their taxable income. Depending on an individual's tax rate, the effective tax rate on corporate income can exceed 60 percent--and even more once state and local taxes are added to the mix.

The Administration proposes to end the double taxation of dividends by allowing individuals to "exclude" dividends from their tax return while preserving the current 35 percent corporate tax that is imposed on this income. The President's plan recognizes that dividends are after-tax payments and puts an end to the discriminatory and unfair practice of making individuals pay a second layer of tax on this income.

Eliminating the double tax on dividend income will increase growth by dramatically lowering the effective tax rate on business equity investment. President Bush understands that economic growth is the first priority. His plan to eliminate the double tax on dividends is a bold and visionary step, and it is part of an overall economic plan that will make our nation stronger and improve the living standards of all Americans.

Daniel J. Mitchell, Ph.D., is McKenna Senior Fellow in Political Economy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. This paper is adapted from testimony presented at a hearing held by the U.S. Senate Special Committee on Aging on February 11, 2003.