TCS Daily

Tax the Dog

By Stephen W. Stanton - April 15, 2003 12:00 AM

I have long advocated the elimination of dividend taxation. My arguments have relied on basic, immutable concepts from corporate finance and microeconomics. I am not alone. Finance jock and NYU Professor Aswath Damodaran analyzed [PDF] the Bush dividend tax plan and reached the same conclusions. However, voting booths measure ideas on their popularity, not their merits.

The merits are clear. In a nutshell, lower dividend taxes raise the after-tax return on invested capital. This creates a favorable shift in the relationship between risk and reward, lowering hurdle rates on capital projects across the entire economy. Companies invest billions of dollars in thousands of projects that would have been scrapped in a higher-tax business environment. As a result, the economy grows faster, absorbing more unemployed workers, growing the tax base, and reducing the fiscal burden of welfare and unemployment benefits. Lastly, companies reduce their exposure to debt, causing bankruptcy and default rates to decline, reducing the mass layoffs and stabilizing the labor market.

Unfortunately, complicated finance concepts are not accessible to many people, and they do not fit on a bumper sticker. In spite of the overwhelming evidence to support dividend tax relief, simplistic critics deride the proposal as a "tax cut for the rich". Instead of focusing on finance and economics, I should have emphasized marketing. While I struggled to educate voters about tax policy, the Democratic National Committee has treated the tax issue as product to sell.

The DNC avoids serious economic arguments entirely, instead relying on misdirection, discrediting the entire GOP proposal as wagging the dog. Their website has a whole section devoted to "President Bush's 2004 Reelection Tax Scheme." (I refuse to provide a link) Given the fundamental weakness of the Democrats' position, their PR campaign has been fairly effective.

How effective? AEI Resident Fellow Karlyn Bowman has put together what may be the most extensive compilation of poll data on taxation today. The results are striking.

The study indicates that "Democrats usually have the edge when it comes to fairness issues, including tax fairness." Of course, fairness is a much easier concept to grasp than economically optimal tax policy. Marxist redistribution schemes attempt to create equality of condition, which many would consider the epitome of fairness.

Democrats have waged class warfare so successfully because Americans "like the idea of the rich paying a greater percentage of their income in taxes." However, Democrats depend on voter ignorance. Even as today's Democrats protest cutting the top individual tax rate to 35%, "A handful of questions asked in the 1990s show that people think Americans should not pay more than 25 percent of their total income in taxes."

Moreover, for decades, "people have told pollsters that the tax system helps the rich". The polling data gives Republicans the brunt of the blame. Of course, the rich pay about twice the tax per dollar of income as the middle class, including Social Security. Fewer than 3% of Americans bear the majority of the tax burden. (Does the tax system help them?) Interestingly, most people consider their annual tax bill "fair", though they pay only a fraction of their pro-rata share of government expenditures.

In the battle for hearts and minds, Democrats have played their hand well. There is a large gap between perception and reality. Democratic electoral success depends on maintaining current misconceptions (or adopting more sensible tax policies). Yet for all their polling success, Democrats face several key disadvantages against Republicans.

According to the study, "when the question is asked in a straightforward manner, people almost always say they favor a cut in federal income taxes." Tax rates have only crept higher because "politicians have a lot to lose by raising taxes, but little to gain by promising to cut them. Politicians' promises to cut taxes have little credibility nationally, though they are obviously important to subgroups such as the Republican activists."
In other words, people like tax cuts, but hate empty promises.

President Bush promised and delivered one tax cut already, and he's working on his second. That just might give Republican tax cutters the credibility they need to be taken seriously. (According to Gallup, a majority of voters already approve of Bush's handling of taxes.)

Tax simplification is another weak issue for Democrats. When RoperASW asked how voters they felt about doing taxes in 1996, 37% were dissatisfied, 18% were angry, and 11% were boiling mad. More than 60% of taxpayers believe the tax system needs major changes or a complete overhaul. Polling data proves voters favor Republicans to make such reforms. Bowman's study goes far deeper than the few points I touched upon here. I encourage you to look at her work to gauge public opinion on every aspect of taxation. There is a big difference between knowing what needs to be done, and actually doing it.

If democracy were perfect, the best ideas would always win. However, as Churchill remarked, "Democracy is the worst form of government except all those other forms that have been tried from time to time." Every good idea can fall victim to the unfortunate trinity of ignorance, apathy, and partisanship. We can win the argument, but lose the election.

Polls count. We live in a democracy. We make our own laws. Yet the vagaries of electoral policies have created a tax code too complex to understand. To enforce its provisions, as Bowman reminds us, we rely on IRS audits that we hate more than root canals.

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