TCS Daily

Half a Loaf is Pretty Good

By Kevin Hassett - April 17, 2003 12:00 AM

With the budget season upon us, browbeating and horse trading are the order of the day. President Bush signaled that he would be willing to accept a compromise bill that reduced his original tax cut proposal by about $200 billion. Under such a compromise, some changes to the centerpiece of the President's plan - the dividend tax cut - will be inevitable. Rumor has it that lawmakers are currently considering changes that look like a pretty dramatic reduction in the tax cut, but are not nearly as bad as they seem.

This possibility exists because of a weird technicality that arises when you attempt to "end the double taxation of dividends." If you want to end double taxation, then you have to be sure of single taxation. Mechanically, the President's plan accomplishes that by allowing shareholders to receive a dividend tax free if the corporation paying the dividend has already exposed the income to taxation. Under "proper" conditions, the dividend tax has been zeroed out.

If, on the other hand, the corporate income has been "sheltered" then the distribution is subject to personal income tax. Because of this provision, the incentive effects of lower dividend taxes are muted. Alternative plans that ostensibly provide for a smaller tax rate reduction at the individual level but do not connect the reduction to "sheltering" activity at the corporate level can have incentive effects that are similar to the President's proposal. It is even possible that a dividend tax of 18 percent at the individual level will be about the same as the President's zero tax rate in effect.

A simple example should help make this more transparent. Suppose that a company has $110 in income and has a deduction (perhaps for depreciation) that is worth $10. If the company claims the $10 deduction then it has $100 in taxable income, and pays a corporate tax of $35. If the company then pays the left over $65 as a dividend to its shareholder, then the shareholder pays no additional tax. Suppose that the firm also decides to distribute the $10 it has in cash that was sheltered. At that point, the shareholder will have to pay tax on the income, since it never faced the first level of taxation at the corporate level. Suppose the shareholder has a tax rate of 35 percent. In that case, when he receives the $10, he will have to pay $3.50 tax, leaving him with $6.50 after tax. His total after-tax benefit from both dividends is $65 + $6.50 = $71.50. Notice that this is the same after-tax income he would have received if the company had not claimed the deduction. In that case, the company would have paid 35 percent tax on $110 ($38.50), but then it could distribute the left over $71.50 tax free. The conclusion is quite striking. The deduction has completely lost its economic value. Its only effect is to move $3.50 tax from the corporate level to the individual level.

As we move from the simple example to the real world, a number of complexities arise. It turns out that the value of deductions does not disappear entirely if companies pursue the strategy of retaining earnings that have been sheltered. In that case, the value of a deduction is reduced by the capital gains tax rate that shareholders eventually will have to pay. A simple exclusion has no such offset, so it can provide a similar incentive effect for smaller tax rate reductions.

So what does it all mean? My analysis suggests that the effect on the incentive to purchase capital equipment of the President's proposal is about the same as would result from an exclusion of dividend income at the personal level of between 50 and 60 percent. Thus, if you read stories in the press stating that Congress has cut the President's bill in half it may well be a bill with virtually the same economic consequences. Half a loaf can be the same as a whole loaf when the loaves are different sizes.

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