TCS Daily

A Better Way?

By Jaffer Qamar - January 16, 2003 12:00 AM

President Bush's proposal to eliminate the dividend tax is welcome. But the plan's opponents, recognizing its political and economic attractiveness, are trying to squash the proposal by arguing that (a) it favors the rich and (b) investors will incur the cost of shuffling their tax-deferred savings accounts. Specifically, if dividends are not taxed, individuals will be induced into moving dividend-paying stocks out of their tax-deferred plans, or else the dividends will be taxed when funds are, later, withdrawn from the plans.

Opponents would be correct on their second argument, but not the first. To be sure, the second argument could be sufficient to kill the President's proposal. Changes to the internal revenue code would have to be significant. Accountants and lawyers will rejoice if the President's proposal is passed.

Instead, a proposal that allows firms to deduct dividends from corporate income might pass the legislative blockade and avoid the economic costs of individuals withdrawing dividend-paying stocks, prematurely, from tax-deferred saving plans. It would also have the following advantages:

  • First, it would eliminate the tax-advantage that debt currently enjoys - i.e., the interest on debt is deductible from corporate income before the tax due is computed. Thus, firms will want to convert their debt into preferred or common stock. This would strengthen their balance sheets.

  • Second, opponents alleging that the President is pandering to the rich would retreat from class-warfare rhetoric. Of course, they would then accuse him for tangoing with the corporations if he proposed deduction of dividends. Although most people have yet to realize that corporations too receive dividends when they hold the stocks of other corporations and elimination of the dividend tax is a relief for all investors - corporate and individual. On the other hand, if the dividends were deductible from corporate income, all investors would continue to pay taxes on both dividend and interest income.

  • Third, since the federal and state corporate income tax rates are higher than the average marginal tax rates for individuals, the deduction (to businesses) could mitigate tax distortions on our economy more effectively than purging the dividend tax.

  • Fourth, the deduction gives a direct tax break to corporations instead of to the individuals who may invest money abroad or buy foreign goods. Thus, the deduction would stimulate investment, create jobs and induce firms to payout more dividends that, in turn, would stimulate consumption.

  • Fifth, changes to the internal revenue code would be trivial if the deduction were permitted - not so if the dividend tax were eliminated.

  • Lastly, the deduction would buoy stock prices more because firms' after-tax profits would be greater, whereas, elimination of the dividend tax would only induce a demand for dividend-paying stocks.

Either proposal will draw opposition. The political and economic calculus will determine which proposal, if either, is legislated.

The author holds a Ph.D. in Economics and an MBA, both, from the University of Chicago and is the President/CEO of SmartPad, Inc., a San Francisco company that makes laptops.

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