When President George W. Bush unveils his economic stimulus plan later this month, one key component will almost certainly be a proposal to reduce double taxation of dividends. Currently, companies pay taxes on their profits, and then stockholders pay taxes on whatever portion of those profits is paid out in the form of dividends. Bush is likely to propose allowing individuals to exempt fully half of their dividend income from income taxes (page 34). That would be beneficial for many high-income taxpayers who have big stock portfolios, effectively bringing the tax rate they pay on dividends down to roughly 20%, about the same as the rate on capital gains. Alternatively, the Bush Administration may simply tax dividends at the capital gains rate.
In theory, such a reduction--long advocated by many conservative economists, including Council of Economic Advisers head R. Glenn Hubbard--makes some sense. In the short run, a lower tax on dividends could boost the stock market by making dividend-paying stocks more attractive. Over the long haul, such a cut would lower the effective rate of taxation on capital, which would boost aftertax returns on investment and encourage capital spending.
Reducing the tax on dividends would also lessen the incentive for companies to raise money through borrowing rather than equity issues. Today, interest payments on debt are deductible from income, while dividend payments on stock are not. In part, that explains why corporate debt soared in the 1990s, while--despite all the attention given to initial public offerings--the net issuance of stock was actually negative. In fact, companies bought back roughly $570 billion in stock from 1998 to 2000, even taking into account all the shares issued by the dot-coms and other IPOs. That encourages ever-increasing leverage in the corporate sector, which makes the financial system more unstable.
But let's not deceive ourselves. Even as economists complain about double taxation of dividends, corporations have been aggressively taking advantage of a variety of loopholes and complicated tax dodges--including moving their headquarters overseas--to lower their tax bills. That's a big reason why corporate income taxes have steadily fallen from over 12% of federal revenues in 1997 to less than 10%. Such strategies have helped make average Americans even more cynical about the tax system.
So if Bush wants to help the economy in the long term, he should combine a reduction in the dividend tax with potent legislation against legal but questionable corporate tax shelters. Also needed is much more active enforcement against illegal corporate tax dodging. Companies should be forced to disclose when they undertake transactions simply to evade taxes, while facing stiffer penalties for tax-evasion maneuvers later deemed to be unlawful. In addition, it should be more difficult for companies to claim a headquarters overseas for tax purposes when their real decisions are made here.
Indeed, any cut in the dividends tax should be part of a broader move toward simplification of a far-too-complicated tax code. Such a combination--lower taxes on dividends plus lower tolerance for corporate tax chicanery--would produce a simpler, more efficient, and fairer tax system. That's something everyone can support.
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