TCS Daily

Tax Cut Victory

By Kevin Hassett - May 16, 2003 12:00 AM

The Senate passed a bill last night that did not include a lengthy phase-in of dividend tax reductions. In the Senate bill, dividend taxes will be cut in half this year, eliminated next year, and reborn in 2007. Given the bizarre political dynamics of the Senate, this bill is a solid effort, and a great place to start a negotiation with the House.

The bill is much improved over trial balloons that floated around D.C. in the weeks leading up to the vote. Previous efforts in the Senate met cost targets by phasing the tax cuts in gradually. As mentioned in this space, lengthy phase-in periods could lead to odd circumstances where firms delay paying any dividends at all until the tax rate reduction has taken full effect. If GM pays you a $100 dividend this year, you might pay almost $40 in tax. If GM pays you a $100 dividend a few years from now, you pay no tax. These incentives might turn out to be a big deal. I could even envision class action suits where shareholders seek damages because firms paid dividends too early. But with the latest Senate effort, the dividend tax is zero starting January of next year and 50 percent this year. If the conference changes that rule to making all dividend tax-free starting in June, then about half of dividends paid this year will be tax free, and there will be no odd timing effects from the bill.

The sunset of dividend tax relief in 2007 was certainly not desired by dividend tax reduction proponents, but the budget hawks in the Senate like such things, and their votes are necessary to pass bills. Sunset provisions like this should not be nearly as vexing to companies as phase-ins. This is because there is already a great deal of uncertainty concerning tax rates off in the future. If the Democrats recapture power, they will likely raise rates. The probability of such an event is certainly not zero. If the Republicans maintain power, they will extend the period where dividends are tax-free indefinitely. It may be that the sunset has some minor effect on the probabilities, but I doubt that that will have a material effect on anything this year or next.

So the House and Senate will meet to reconcile their two different approaches to dividend tax relief, and both have passed bills that contain a great deal of the vision that President Bush first proposed in January. Which bill is better? On the one hand, the House bill has a permanent tax reduction, so the sunset provision is not an issue. One might argue that this feature constrains future Democratic Congresses and has some value. On the other hand, the tax rate reduction in the Senate bill is a bit larger, and could well have a bigger effect on the economy, especially if firms ignore the sunset for now. It will be interesting to see how it turns out, but there is no doubt that the compromise that emerges from conference will be good for investors and the economy.

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