TCS Daily

How, Not Whether

By Stephen W. Stanton - January 8, 2003 12:00 AM

Double taxation of dividend income has been a huge strain on the U.S. economy. This quirk of our tax code has driven a wave of bankruptcies, exacerbated stock market volatility, discouraged investment, slowed economic growth, cost America jobs, and added to our trade deficit. The double tax still exists for two reasons. First, politicians are addicted to tax revenue, loath to give up even the most injurious taxes. More importantly, dividend tax relief is derided as a "tax break for the rich", the rallying cry for class warfare.

Fortunately, the Bush administration has the courage to take on this politically sensitive issue. In his recent economic stimulus proposal, President Bush advocated eliminating double taxation altogether. This is undoubtedly positive news for the economy. There are two ways to end double taxation: Eliminate the tax at the corporate level with a deduction for dividends paid, or at the individual level with an exemption for dividend income. Either solution leaves only a single tax on corporate profits. Bush proposed relief at the individual level, which would allow shareholders to receive dividends tax-free. Corporations would not receive a deduction for dividends paid.

The New York Times rightly points out that tax-free dividends provide opportunities to manipulate capital gains, which are still taxable. However, there are already loopholes to escape dividend taxation. To illustrate, take a company like Microsoft, which currently pays no dividends. As of this writing, Microsoft trades at $55 per share. Assume you paid $35 a share, split-adjusted. If you sold today, you would realize capital gains of $20 per share. At the top capital gains rate of 20%, you would be taxed $4 for each share you sold.

Microsoft has enough cash to pay a huge dividend. The company might consider paying a dividend of $20 per share. Under current law, affluent shareholders would face a tax of 38.6% on dividends. The average schoolteacher would pay a tax of 27%, more than Bill Gates pays when he sells his shares (even 27% is more than 20%). Surely, dividends are not a tax-efficient way to return money to shareholders.

The company can get around dividend taxation through a share buyback. Instead of paying everybody a $20 dividend, the company can simply buy a few billion shares in the open market at $55 a piece. Whereas an entire dividend would be subject to tax at an individual's highest tax rate, a buyback is subject to more favorable capital gains treatment. Individuals that sell shares back to Microsoft pay tax on their gains at a top rate of 20%. If such a buyback were executed on a pro-rata basis, with every shareholder selling an identical fraction of his holdings, the transaction would be economically identical to a dividend. The only practical difference between a pro-rata buyback and a dividend is tax savings of several hundred million dollars.

Under the Bush proposal, dividends would be tax-free. This largely eliminates the need for share buybacks. Moreover, it becomes possible for many shareholders to avoid capital gains taxes altogether. Without the barrier of dividend taxation, companies such as Microsoft and Berkshire Hathaway would be more likely to return cash to their shareholders.

Let's return to the earlier example of a $55 stock with a $35 cost basis. Instead of letting investors face a $20 capital gain and $4 tax bill, under the Bush proposal Microsoft could distribute a tax-free dividend of $20 per share. As a result, the price of Microsoft stock should drop by roughly $20, the amount of the dividend. Shareholders could collect their dividend, sell their stock for $35, put all $55 in their pockets, and pay no tax at all.

However, as good as the Bush proposal is - and it is good - there are weaknesses. First, tax policy still interferes with the economics of corporate finance. Interest on debt remains deductible from corporate income, while dividends are not. This creates the need to tweak the mix of debt and equity depending upon profit expectations and shareholder composition.

For example, under both current law and the Bush proposal, pension funds and university endowments pay taxes on neither dividends nor interest income. In addition, all assets held in IRA's and 401(k)'s are fully taxed upon distribution, regardless of any distinction between dividends, interest, and capital gains within such accounts, even under the Bush plan. For such investors, equity would be taxed once, but corporate debt securities are never taxed. Tax-exempts would likely shift assets from equity into debt markets.

More importantly, dividend tax relief at the shareholder level is politically difficult. The top corporate tax rate is 35%. The top individual tax rate is 38.6%. When corporate profits taxed at 35% are distributed tax-free to shareholders in the 38.6% tax bracket, such individuals get an effective rate reduction of 3.8%, a savings of more than 9%. This fact will be rehashed endlessly by class warmongers. However, the problem has an easy solution. Simply requiring top-tax bracket taxpayers to pay the 3.8% tax differential would have largely eliminated the issue.

However, Bush has taken a bolder, more sensible, yet politically difficult approach. He proposed harmonizing the top corporate and individual income tax rates, capping both at 35%. This ensures that all profits will be subject to uniform tax treatment, regardless of legal structure. With unemployment hovering at decade highs, a rate cut for the rich is a tough sell, even if it is necessary for a sound dividend tax policy.

The Bush plan does have strengths. For example, allowing a corporate tax deduction for dividends would likely cost the government significantly more tax revenue than Bush's shareholder level relief. A large share of corporate stock is held by pensions, personal retirement accounts, and other tax-exempt investors. Since they pay no taxes at the shareholder level, they are not currently subject to double taxation. If corporations were allowed a dividend deduction, all profits distributed to tax-exempt shareholders would never be subject to even a single level of taxation. Zero taxation is a bad idea. It would give multinational corporations access to tax-free capital while mom-and-pop stores pay tax at individual rates.

The bottom line: The Bush plan is good. The proposal effectively eliminates double taxation and the economic baggage that comes with it. The plan is not perfect, but as long as our system taxes capital gains and exempts certain investors, there is no better solution. There is room for tweaking, and there are easy ways to disarm the class warriors without compromising the principle of single taxation.

Economists and pundits will provide endless commentary in the coming week. Already, Robert Reich called dividend tax relief, "a waste of taxpayer money". (Evidently, spending and investing your own money is a waste because the government spends it so much better.) Most opinions, like Reich's, will fall along political lines, either supporting or denouncing dividend tax relief. However, we have a popular president whose party controls both houses of Congress. Dividend tax relief will very likely become law. It is important that some analysts spend less time discussing whether we should have dividend tax relief, and more time figuring out how to best implement it. Dividend tax relief is important. Let's do it right.

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