February 3, 2003 | Center for Data Analysis Report on Taxes
For example, CDA estimates indicate that the employment level would average 285,000 additional jobs from 2003 to 2012. In addition, CDA analysis has found that ending this double taxation would reduce federal revenue by $64 billion over ten years, or 79 percent less than an estimate that does not account for the effects of greater economic activity following the proposal's implementation. The CDA's $64 billion estimate is slightly more than one-fifth of the $364 billion cost estimated by the United States Department of the Treasury for President Bush's proposal. The CDA and Treasury analyses consider slightly different proposals, but this cost difference is largely due to the more realistic estimation method used by the CDA.
The Treasury Department employs an erroneous "static" approach to estimate the revenue effect of tax law changes, while the CDA uses dynamic simulation, a method that accounts for the impact that federal tax policy may exert on economic growth. Figure 1 shows that the estimation method chosen can make a large difference in the projected revenue loss. The figure compares the CDA's own static and dynamic projections of the federal revenue change resulting from a particular plan to end the double taxation of dividends.
This double taxation has two stages. The first stage occurs when the federal government taxes shareholders on corporate income through corporate taxes. The second occurs after the corporation has distributed part of the post-tax profits to the shareholders in the form of dividends. In this second stage, the federal government taxes shareholders on their dividend income through the personal income tax.
Economists have long argued that the double taxation of dividends reduces the after-tax return on capital in the nation's economy and thus discourages investment-in other words, purchases of new business equipment and machinery. This reduced investment in turn weakens economic growth. Consequently, eliminating the double taxation would spur investment and improve the economy's long-term growth. Recognizing these economic benefits, several nations, including Australia, France, Italy, Canada, Germany, Japan, and the United Kingdom, have abolished or reduced their double taxation of corporate dividends.
One recent legislative proposal to abolish this double taxation in the United States was sponsored by Representative Christopher Cox (R- CA). The Heritage Foundation's CDA used this proposal to illustrate the economic and federal fiscal effects of ending the double taxation of dividends. To estimate these effects, Heritage analysts employed the DRI-WEFA U.S. Macroeconomic Model and the Center's own Individual Income Tax Model. Assuming the reform becomes law in September 2003, the investigation found that:
How the Double Taxation of Dividends works
The double taxation of dividends is one of the clearest examples of the way the nation's current tax law reduces the return on capital and, therefore, the incentive to invest. The following example illustrates the effect of this double taxation.
Consider $100 in pre-tax profit earned by a corporation in the flat 35 percent bracket. Suppose that, after paying the $35 in federal corporate taxes, the firm distributed the remaining $65 to a shareholder. Suppose, further, that this individual was in the 27 percent personal income tax bracket. This shareholder would pay $17.55 in personal income taxes on these dividends. This second round of taxation would leave only $47.45 of the original $100 in corporate profits. In other words, for every $100 in pre-tax profits, the federal government would absorb approximately $52.55 in taxes.
In contrast, consider the taxes the shareholder might have paid if that person could have received the dividend before the firm paid corporate taxes. In this case, the corporation would have paid the shareholder all $100 in the form of a dividend. The shareholder would then have paid $27 in personal income taxes on the dividends, leaving that investor with $73 out of the $100 in pre-tax corporate profit. As this example shows, the double taxation of corporate dividends reduced the shareholder's return on capital from $73 to $47.45-a reduction of 35 percent (or $25.55). In the aggregate, this lower return on capital means that there is less investment than there would otherwise have been.
DYNAMIC SIMULATION OF MACROECONOMIC AND FISCAL EFFECTS
Heritage economists use dynamic simulation to project the economic and fiscal effects of proposals for tax changes. This method contrasts with the static approach used by the U.S. Department of the Treasury and the Congressional Joint Committee on Taxation (JCT) , which assumes that federal tax policy does not affect economic growth.
In determining the fiscal effects of tax change proposals, the static approach does take into account some of the ways taxpayers alter their tax reporting and filing in response to changes in tax law. For example, the static approach takes into account that taxpayers could increase their itemized deductions or shift compensation from taxable to tax-exempt (or tax-deferred) forms in response to certain changes in the tax laws. However, the static approach does not take into account the way investors and workers alter their consumption, investment, saving, and work effort in response to changes in tax policy. This is a major shortcoming of the static approach because economic theory suggests that tax policy changes bring about such alterations.
Such changes in taxpayers' behavior could affect important macroeconomic variables, including employment, personal income, and GDP. Thus, changes in tax law often exert an impact on the nation's economy. The static approach necessarily ignores these impacts, leading to systematic inaccuracies in the estimates of the fiscal effects of tax policy changes.
In contrast, The Heritage Foundation uses dynamic simulation in evaluating the fiscal and economic effects of tax policy proposals. Dynamic simulation takes into account the impact that tax policy legislation can exert on taxpayers' economic decisions, such as consumption, investment, saving, and work effort. Dynamic simulation, therefore, can reflect changes in macroeconomic variables that new tax policies can cause.
For example, if a tax rate reduction were to strengthen national economic growth and therefore increase the tax base, a resultant increase in tax collections could partially offset the federal revenue losses caused by the rate reduction. Static analysis would not take such an offset into account and therefore would overestimate the net decline in federal tax collections resulting from the tax rate reduction. Dynamic analysis would include this offset because it would take full account of the economic benefits that the tax rate reduction could cause. It would also capture the ways in which these benefits could strengthen the economy, bolster the tax base, and ameliorate the reduction in tax collections.
In analyzing the economic and fiscal impact of the Cox proposal, CDA analysts made a number of assumptions regarding the alternative minimum tax, capital gains taxation, federal spending, and the date the bill would be enacted. These assumptions were as follows.
MACROECONOMIC AND FISCAL EFFECTS OF THE COX PROPOSAL
Heritage economists used a modified version of the DRI-WEFA U.S. Macroeconomic Model to conduct a dynamic simulation of the effects of Representative Cox's bill. Specifically, Heritage economists developed a baseline by adapting the DRI-WEFA macroeconomic forecast from September 2002 to yield the same economic and budget projections as those of the Congressional Budget Office (CBO) in August 2002. Thus, the economic baseline employed in this analysis should be comparable to baselines used by the CBO and JCT in analyzing this legislation. The results of the dynamic simulation are displayed in Table 2.
Specifically, the dynamic analysis projects that the Cox proposal would:
President Bush has proposed reforming the U.S. tax code to abolish the federal double taxation on corporate dividends. Economists have long argued that this double taxation exerts a harmful effect on the nation's economy because it increases the user cost of capital and therefore reduces investment in the United States. Last fall, Representative Christopher Cox introduced legislation that would end this double taxation.
This Heritage Foundation working paper investigates the 10-year economic and fiscal impact of Representative Cox's proposal to abolish this double taxation. It finds that the proposal would, by the year 2012, improve growth in the nation's GDP, add hundreds of thousands of jobs to the economy, increase investment, strengthen growth in disposable income, and add to the nation's capital stock.
Norbert J. Michel and Alfredo Goyburu are Policy Analysts, and Ralph A. Rector, Ph.D., is a Research Fellow, in the Center for Data Analysis at The Heritage Foundation.
Heritage Foundation economists in the Center for Data Analysis (CDA) used a multi-step procedure to analyze the budgetary and economic effects of the tax law change proposed by Representative Cox.
First, CDA economists adapted the September 2002 forecast from the DRI-WEFA U.S. Macroeconomic Model to make it congruent with the long-term budget and economic projections published by the Congressional Budget Office in August 2002. CDA analysts then used this forecast as the baseline by which to analyze the effects of the Cox proposal.
CDA economists then used the Center's Individual Income Tax Model to generate a static estimate of the change in federal tax collections resulting from the Cox proposal. This static estimate serves as an essential starting point in analyzing the fiscal impact of proposed changes in tax policy. However, as explained above, to use this estimate as an ultimate forecast of the federal revenue lost under the Cox proposal would be to implement an erroneous static approach. The more accurate, dynamic approach would take into account the proposal's macroeconomic effects. These effects include changes in GDP, interest rates, employment levels, price levels, investment, and other quantities. Changes in any of these macroeconomic variables could affect tax revenues significantly.
Next, the Center's analysts introduced these tax collection changes and other implications of the Cox proposal into the adapted DRI-WEFA U.S. Macroeconomic Model. CDA researchers then executed the simulation and developed a dynamic estimate of the fiscal and macroeconomic effects of the Cox proposal. The researchers noted changes in key macroeconomic and budget variables compared with their values in the original adapted version of the model. Differences in these key variables were attributed to the response of the U.S. economy and federal budget to the tax policy change-that is, the dynamic response. (See Table 2.)
The DRI-WEFA model contains a number of variables that can be altered to simulate policy changes. Using these variables, CDA analysts introduced static-model tax revenue and economic behavior responses attributable to the enactment of Representative Cox's proposal to end the double taxation on corporate dividends. The variables altered include:
Federal Marginal Tax Rate on Corporate Income
The Cox dividend proposal would significantly reduce the effective federal marginal tax rate on corporate income. CDA analysts altered a variable that controls this quantity in order to reflect this reduction.
Federal Average Tax Rate on
CDA researchers manipulated a variable that controls the federal average corporate tax rate. This variable was changed so that the average rate would remain unchanged compared to the baseline value, in spite of the alteration of the federal marginal corporate tax rate.
Federal Average Tax Rate on Personal Income
The Cox dividend proposal would abolish the double taxation of corporate dividend income by returning a credit that could be claimed against personal income tax liability. CDA analysts altered this variable to capture the static reduction in federal personal income tax collections resulting from the enactment of Representative Cox's legislation.
Personal Dividend Income
The Cox dividend proposal is expected to boost corporate payments of dividends. This increase would have both short-run and long-run components. In the short run, existing C-Corporations would increase their dividend payouts as a share of after-tax profits. They would do so in response to shareholder demand. In the long run, the Cox dividend proposal would reduce the user cost of capital. The lower user cost of capital would boost corporate profits, leading to an increase in payouts of corporate dividends. CDA analysts recognized this increase through an appropriate change in a model variable that controls personal dividend income.
The Cox dividend proposal is expected to increase personal dividend income compared to its level in the baseline forecast. As indicated in the simulation, part of this increased dividend income comes from an increase in firm profitability, as described above. The rest of the dividend increase would represent a shift from corporate retained earnings to increased payouts of dividends. CDA economists adjusted a variable that controls after-tax corporate profits to reflect this shift.
The bill sponsored by Representative Cox would eliminate the double taxation of dividends paid by C-Corporations through an imputation credit method similar to that used in several other countries. This method adds an amount equal to the corporate layer of the tax on the distributed dividend to the individual shareholders gross income and then gives the shareholder a tax credit equal to that amount.
The Cox approach has the effect of removing the corporate layer of taxation from dividends by returning it to shareholders at the personal level, via a credit. Although corporations continue to pay income taxes on the dividends they distribute, individuals receiving dividends end up with a lower tax liability to offset the corporate income tax.
This proposal would not change any aspect of taxation at the corporate level. In addition, the shareholders legal obligation to report dividends received as ordinary personal income would remain unchanged. However, in addition to the dividends, shareholders would have to add to their taxable income the amount that each corporation paid in taxes on the profits from which each dividend payout came.
By adding the corporate tax payments on each dividend payout to their ordinary personal income, shareholders would be said to be grossing up their dividend income. The corporate tax payments on the dividendsthat is, the amount by which the dividend payments would be grossed upwould also become a non-refundable credit that shareholders could claim against tax liability.
Thus, the gross-up amount would both add to and subtract from each shareholders tax liability. However, the net effect would never be a tax liability increase. The gross-up would increase the shareholders liability by adding to taxable income. On the other hand, the gross-up would reduce tax liability by serving as a non-refundable credit. The effect of the former can never add more in tax liability than the latter reduces. This is because the gross-up increases the shareholders liability only by the amount of the gross-up multiplied by the shareholders top marginal tax rate, while the shareholders tax liability is reduced by up to the full amount of the gross-up.
Table 1 provides an example illustrating how the Cox proposal works for a hypothetical dual-earning married childless couple in the 27 percent tax bracket during 2003. The couple is assumed to own stock in a company subject to the average corporate tax rate of 35 percent. The corporations tax situation is illustrated in the section of the table labeled Corporate Taxpayer (lines 1 to 3). This section shows that corporate tax liability on pre-tax dividends does not change with the proposal. In both cases, the $100 in pre-tax profits is taxed at the corporate rate of 35 percent, leaving $65 that could be paid to individuals in the form of dividends.
The example illustrated in the table sets aside the effect of state and local corporate taxes and further assumes that all of the $65 is paid to the couple in the form of a dividend. Under both current law and the Cox proposal, the couple adds the $65 dividend to its other taxable income (line 8). The couples other taxable income, in turn, is calculated the same way under both current law and the proposal (lines 47). The couple starts with $62,000 in wage and salary income and no other type of income (line 4). It then takes its standard deduction of $7,950 (line 5) as well as its personal exemptions totaling $6,100 (line 6). These deductions leave $47,950 in taxable other income (line 7).
As described above, the dividend payout the couple receives is added to their other taxable income under both current law and the proposal (line 8). However, under the Cox proposal, the dividend gross-up is also added to the couples taxable income (line 9). Under the proposal, the couple applies the same rate structure to their income as under current rules. Under current law, the couple ends up with a total tax liability of $6,652.50 and an after-tax income of $55,412.50 (lines 15 and 16). Under the Cox proposal, because of the dividend gross-up, the couples taxable income (line 10) totals $48,050, not $48,015 as under current law. This higher taxable income incurs a pre-credit tax liability of $6,661.95 (line 11). At this point, the filing couple applies the credit (line 12) and is left with a total tax liability of $6,626.95 (line 15)a $25.55 reduction in tax liability.
The Dividend Detail section of Table 1 shows how the Cox proposal reduces the taxes the couple pays on the dividends it received. For example, under current law, the taxpayers individual portion of the tax on the dividend is $17.55.
Under the Cox proposal, however, the taxpayers individual portion of the tax on the dividend is negative $8 (line 8).Since the personal tax on other income remains unchanged, the taxpayers total tax liability falls by $25.55from $6,652.50 to $6,626.95. Therefore, the Cox proposal lowers the effective personal tax on the dividend by $25.55 for the couple in this example (line 20).
Under current law, the $100 in pre-tax dividend income is reduced by $35 at the corporate level, leaving $65 for the individual, which is further reduced by $17.55 at the personal level (lines 1719). Adding the $35 tax and the $17.55 tax results in an effective personal tax of $52.55. (Adding lines 18 and 19 results in the total on line 20.) When the $52.55 is subtracted from the original $100, the individual investor receives an effective dividend of only $47.45. (Subtracting line 20 from line 17 gives the total on line 21.)
Under the Cox proposal, the effective personal tax on the dividend is only $27 ($65 dividend + $35 credit = $100 x 27% = $27). This means that the effective personal dividend is $25.55 higher, for a total of $73 ($47.45 + 25.55). This new effective dividend is exactly what the individual would have received had the original $100 been taxed only at the personal level ($100 x (1-.27) = $73).
While the corporation pays the same tax on the dividend income that it pays under current law, the Cox proposal has the effect of distributing a dividend that was untaxed at the corporate level. The end result is that one layer of taxation on dividends is removed, resulting in a higher after-tax rate of return on investment.