President Bush deserves an A for putting an important economic issues, the double taxation of corporate dividends, out for discussion. But his proposal to eliminate the income tax on dividends rates a C+ at best.
The administration is willing to confront substantial political opposition to achieve a change that addresses only part of the problems caused by current policy. It would have been better if Bush tried to abolish the corporate income tax entirely. That would be more just and efficient.
It is important to understand just how dividends are taxed. There isn’t a specific federal tax on dividends. Instead, they’re taxed as part of two much broader federal taxes: the corporate income tax and the personal income tax. All but very small, closely held corporations are subject to a corporate income tax. And economists have long argued that the tax introduces perverse incentive to managers who much raise capital for their companies.
They choose between borrowing from banks or other lenders, selling bonds or issuing stock. But they can deduct the interest paid to lenders as a business expense, while the dividend they offer to stockholders isn’t deductible.
That discrepancy–interest deductible and dividends non-deductible–is what most economists identify as the source of the economic inefficiencies that results from “double taxation” of dividends. It induces corporations to seek more debt capital and less equity capital than is optimal. Society as a hole is poorer because we use available capital less efficiently.
It is important to note that perverse incentives don’t affect the person supplying capital, or you the investor. If you buy a bond, you will get interest income and it will be taxed. If you buy stocks, you will get a dividend and that income will be taxed the same as the bond interest income.
Allowing corporations to treat dividend payments the same way they currently treat interest payments–as a before-tax business expense–would be the straightforward way to correct the inefficiencies of existing “double taxation.” The Bush administration chose not to propose this.
Instead, they want to correct the problems caused by disparate treatment of interest and dividends at the corporate payer end by creating an offsetting disparity at the personal payee end. Under the proposal, interest earned on bonds or from banks will remain taxable but dividend won’t.
With this approach, corporate financial officers will still face the same asymmetry. If they sell bonds, the costs of the money is deductible from the company’s earnings. But if they sell stock instead, the cost is not deductible. There will be no change in incentives on the demand side for capital.
The administration’s proposal will change things for investors: Buy bonds and you will be taxed on your earnings; buy stocks and you won’t be.
This will motivate investors to buy more stocks than bonds. As a result, the price of capital in bond markets–interest rates–will go up, and the price of capital in equity markets–dividends relative to earnings–will go down.
Administration economic officials assert the total supply of capital will increase, boosting businesses and creating jobs. I am not yet convinced by their arguments.
While it would be straightforward to tax the acquisition of debt and equity capital identically in companies, there’s a political problem: Exempting dividends from taxable corporate income is essentially the same things as abolishing the corporate income tax. Only earnings retained by the corporation would be taxed and those soon would be zero as corporations learned to pay out all earnings as dividends and sell new shares to fund growth.
The Bush administration knows very well that abolishing the corporate income tax would be very contentious. Many Democrats have built political careers on demagoguery around this very topic.
Common sense should tell people that ultimately all taxes must be borne by some household. In the end, corporate incomes taxes all come out of the pockets of people and only a fraction comes out of the pockets of those people who own stocks. The rest comes from corporate employees or consumers of corporate products.
But Democrats know they can win votes by yelling “tax corporations and not families.”
The Bush administration clearly recognized this political reality in preparing their proposal.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.