The Heritage Foundation

Executive Summary #1640 on Taxes

March 28, 2003

March 28, 2003 | Executive Summary on Taxes

Executive Summary: Pathway to Economic Growth and Tax Reform: Eliminating the Double Tax on Dividends

In a bold move, President Bush has proposed that the double taxation of dividends be eliminated. Under his plan, businesses would still pay tax on corporate income, but individual stockholders would no longer pay a second tax on that income when it is distributed as dividends.

All Americans will gain if the double tax on dividends is eliminated. Federal Reserve Board Chairman Alan Greenspan, who rarely has a kind word to say about tax relief proposals, testified recently that "This particular program will be of net benefit to virtually everybody in the economy over the long run, and that is one of the reasons I strongly support it."

Disadvantages of the Double Taxation of Dividends
Few tax policies are more self-destructive than the double taxation of corporate profit. Double taxation punishes an activity--investment--that is unambiguously good for the nation; encourages taxpayers to put today ahead of tomorrow; retards economic growth by lowering investment; promotes excessive debt; and, combined with other misguided tax policies, hinders America's competitiveness in the global economy.

With dividend income taxed at both the corporate and individual levels, the effective tax rate can easily exceed 60 percent (or even 70 percent for investors living in high-tax states). In addition to reducing the nation's stock of productive capital by causing some taxpayers to forgo investment and instead use the money for consumption, these punitive tax rates misallocate capital by leading taxpayers to shift their investment patterns in ways that are economically less efficient. The net effect is lower wages and slower growth.

Double taxation of dividends imposes a specific hardship on certain classes of taxpayers. The elderly receive almost half of all dividends, and the double tax imposes an average annual tax burden of $936 on nearly 10 million seniors. Many of these seniors rely on dividends for retirement income; yet, their efforts to create a more comfortable existence are undermined by the double tax.

Subjecting dividend income to an extra layer of tax creates a bias for borrowing since equity investment is taxed twice while debt-financed investment is taxed once. This tax bias against equity is so significant that corporate managers have little choice but to over-utilize corporate debt. Companies incur large amounts of debt, making them vulnerable to an economic downturn during which revenues fall while interest costs do not.

Advantages of Eliminating the Double Taxation of Dividends
Under the President's proposal, the effective tax rate on dividend income will drop, in some cases by more than 50 percent, helping the economy grow faster. In addition, by removing a significant distortion in the tax code, ending the double taxation of dividends will create an environment in which decisions are more likely to be guided by economic considerations instead of tax-minimization goals. The main effects include:

  • Increasing investment
    According to the Council of Economic Advisers, "a dividend exclusion could also lower the economy-wide average effective tax rate on capital income by as much as one-quarter...and improve the overall incentive to save and invest."
  • More efficient use of capital
    A 1992 U.S. Treasury Department study found that, even in the absence of increased investment, eliminating double taxation would eventually raise economic output by about 0.5 percent of consumption--equal to about $36 billion each year.
  • Attracting global capital
    Nations with pro-growth policies attract money from investors in other nations. With about $2 trillion changing hands every day in global capital markets, this is an increasingly important reason to eliminate the double tax on corporate profits.

The President's proposal would enhance near-term economic growth by encouraging higher levels of corporate investment and capital accumulation, resulting in greater productivity increases and, therefore, higher wages for workers.

Ending the double taxation of dividends would boost U.S. competitiveness. Only three of the world's 30 developed nations--America, Switzerland, and Ireland--double tax corporate income. And since Switzerland and Ireland have lower corporate tax rates, this means that America has one of the most punitive and anti-growth dividend tax policies in the industrialized world.

Many economists have noted that eliminating this double tax is likely to boost the stock market by 10 percent or more, helping people recover much or even all of their recent losses. Moreover, a 1992 U.S. Treasury Department study estimates that the leverage ratio (the ratio of debts to assets) would fall by as much as 7 percent. This could mean fewer bankruptcies.

The tax code creates a perverse incentive for companies to hoard earnings. The President's plan would end this anti-dividend bias, giving companies an incentive to attract investors by offering dividends instead of promising capital gains. The Treasury Department has also found that state and local government tax revenue would climb by about $20 billion annually because of stronger economic growth.

President Bush's plan to eliminate the double tax on dividends, if implemented, will make the nation stronger and improve the living standards of all Americans. It will make the United States more competitive in the global economy and eliminate a bias against saving and investment, significantly improving the economy's performance.

Ending the double taxation of dividends is also an inherent and necessary component of fundamental tax reform. All proposals to create a simple and fair tax code--such as the flat tax--are based on the notion that income should be taxed only once. President Bush's proposal should therefore be seen as an important step toward a tax system based on sound economics and good tax policy.

Daniel J. Mitchell, Ph.D., is McKenna Senior Fellow in Political Economy in the Thomas A. Roe Institute for Economic Policy Studies, Norbert J. Michel is a Policy Analyst in the Center for Data Analysis, and David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies