The Heritage Foundation

Backgrounder #1631 on Taxes

March 5, 2003

March 5, 2003 | Backgrounder on Taxes

Protecting Seniors from Double Taxation

President George W. Bush has proposed that the double taxation of dividends be eliminated. Under his plan, businesses would continue to pay tax on corporate income, but individual stockholders no longer would have to pay a second layer of tax on that income when it is distributed in the form of dividends. This proposal is good for America and good for seniors.

The President is addressing a very serious problem. The Internal Revenue Code routinely imposes extra layers of taxation on productive behavior such as saving and investment, and the double taxation of dividends is just the tip of the iceberg. Additional forms of double taxation include capital gains taxes, the death (estate) tax, and taxes on interest payments. The 1993 tax bill even instituted an extra layer of tax on Social Security benefits.

Removing or reducing double taxation will lead to more jobs and higher living standards and will make America more competitive in the global economy. Eliminating extra layers of tax will also simplify the tax code.

Perhaps most important, ending double taxation is the right thing to do. People who contribute to our nation's prosperity by saving and investing--and this certainly includes many of the elderly--should not be punished by the tax code.

Double Taxation is Bad for America

Tax policies that punish savings and investment are counterproductive. Every economic theory (including Marxism) teaches that capital formation is necessary to raise wages and stimulate long-term economic growth.

Policymakers who want to boost savings should eliminate the anti-savings provisions in the federal tax code, preferably by replacing the code with a simple and fair flat tax that would end multiple taxation of capital. To the extent that such fundamental reform is not immediately possible, Congress can and should take a number of incremental steps to alleviate the bias against savings and move toward a flat and fair tax system:

  • Make individual retirement accounts (IRAs) universal so that all taxpayers could save as much as they want without being taxed twice;
  • End the double taxation of non-retirement savings;
  • Repeal the 1993 tax increase on Social Security benefits; and
  • Eliminate tax penalties on dividends, estates, capital gains, and other forms of capital.

Double Taxation and the Elderly

While certain taxes, such as the death tax and double tax on dividends, are not explicitly designed to hit seniors, the elderly bear a disproportionate share of the burden. Seniors have higher levels of saving and investment than younger Americans. In part, this is simply because they have had the opportunity to accumulate capital during their working years. But there are also reasons why the elderly, in particular, save--including the need for economic security and the desire to provide a nest egg for their families.

These goals, however, are sabotaged by the tax code, which imposes numerous forms of double taxation. Three of the most onerous are:

  • The death tax
    The death tax is imposed when taxpayers' assets are above a specified value at the time of their death. Given that assets are typically purchased with after-tax income, the death tax clearly qualifies as double taxation. Indeed, because many financial assets in a taxpayer's estate may already have been subjected to other layers of taxes, the death tax often is a form of triple, or even quadruple, taxation.
  • The tax on Social Security benefits
    This is one form of double taxation that specifically targets the elderly. Thanks to the 1993 tax increase, single retirees with incomes above $34,000 and couples with incomes over $44,000 now must pay tax on 85 percent of their Social Security benefits. Since only the so-called employer share of the tax is paid in pre-tax dollars--meaning only 50 percent of Social Security taxes is deductible--it is double taxation to tax more than 50 percent of benefits.
  • The dividend tax
    Returns on corporate investments are subject to double taxation. First, the income is hit by the corporate income tax (and the United States has the fourth highest rate in the industrialized world). Then, when profits are distributed as dividends, the same income is taxed a second time at the individual level via the personal income tax.

Tax Relief for the Elderly

Fixing these flaws in the tax code is good for economic growth, good for American competitiveness, and good for the elderly. The White House has announced that "almost half of all savings from the dividend exclusion under the President's plan would go to taxpayers 65 and older," and that "the average tax savings for the 9.8 million seniors receiving dividends would be $936." 1

A Heritage Foundation analysis of the data confirms that the elderly would be major beneficiaries of dividend tax reform. Among post-retirement age taxpayers who receive dividends, the median taxpayer (single, married, and combined) receives dividend income of $2,406, with an after-tax income of $35,544. The median single taxpayer in this group has a lower after-tax income of $21,844 and a higher dividend income of $3,184. The median married taxpayer in this group has an after-tax income of $44,921 and a dividend income of just under $2,000.

The death tax is scheduled to disappear in 2010. That is the good news. The bad news is that it reappears in 2011. This tax reform must be made permanent if it is to boost economic growth and rescue older Americans from this pernicious form of double taxation. Last but not least, the double tax on Social Security benefits currently is part of the tax code, and it does not appear that this black mark in the system will be erased anytime soon.

Good Tax Policy will Boost Economy and Increase Wages

Removing or reducing all forms of double taxation will lead to more jobs and increased wages, boosting the economy and raising living standards.

Eliminating the Dividend DoubleTax

Many 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 corporate investment.2 This means reduced purchases of new equipment and machinery, which translates into diminished economic growth. Consequently, eliminating this double taxation would spur corporate investment and improve the economy's long-term growth.

Both empirical evidence and economic theory indicate that eliminating the double taxation of dividends would lower the cost of capital and, in turn, increase investment and economic growth. Since the United States is one of only three developed countries without some form of protection from the double taxation of dividends, much of the empirical evidence on the benefits of eliminating this double taxation is derived from the experiences of other countries.

In 1987, both New Zealand and Australia implemented a dividend "imputation credit" mechanism to eliminate the double tax on dividends.3 This method, which has the effect of adding back the amount of the corporate layer of tax to the dividend received by the shareholder, was found to increase capital investment in both countries.4 Furthermore, the imputation credit employed in Australia was found to offset the investment-dampening effects of an increase in the capital gains tax.5

In a 1984 paper, James Poterba and Lawrence Summers tested several competing hypotheses regarding the economic effects of dividend taxation, using data from Great Britain.6 Unlike the United States, Great Britain has experienced several dividend tax reforms since the 1950s, a condition that makes empirical testing more straightforward. Poterba and Summers found that the double taxation of dividends in Great Britain lowered corporate investment and worsened distortions in capital markets.

One of the U.S. tax reforms that lends itself to this type of empirical study is the Tax Reform Act of 1986 (TRA 86). A 1991 paper by Serge Nadeau and Robert Strauss notes that TRA 86 significantly reduced the tax advantage of retained earnings over dividends.7 The authors' model estimated that this tax reform reduced the cost of equity capital by about 30 percent. In 1992, Jason Cummins and Kevin Hassett also studied the impact of TRA 86 and found that it lowered the cost of capital and increased investment.8

Recently, Heritage Foundation economists created a simulation of the effects of President Bush's dividend tax reform bill and found that ending the double tax on dividends would lead to higher investment and economic growth.9 Specifically, it would:

  • Increase the employment level by an average of 576,000 taxpaying jobs per year;
  • Increase gross domestic product (GDP) by an average of $51 billion; and
  • Increase purchases of business equipment by an average of $54 billion.

Interestingly, this added economic growth would generate revenue for the government. Although the revenue feedback--or supply-side effect--of eliminating double taxation almost surely would not be enough to offset the static revenue loss, the simulation indicated that the President's proposal would reduce revenues to the Treasury by less than half of the so-called static cost (which assumes no added economic growth and investment): In contrast to the predicted static cost of $360 billion, ending the double taxation of dividends would have a sufficiently large impact on economic growth that Treasury revenues would fall by only $131 billion over 10 years.

Repealing the Death Tax

Although the death tax is imposed at the time of an individual's death, its negative impact results from the decisions regarding savings and investment that are made in anticipation of this tax burden. It is quite likely that no tax does more damage to the economy in comparison to the relatively small amount of tax revenue that is generated. The death tax simultaneously discourages the accumulation of new capital and encourages the misallocation of existing capital. Repealing the death tax, therefore, would have enormously positive consequences.

Congress's Joint Economic Committee, for instance, estimates that the death tax has slashed available capital stock by $497 billion (3.2 percent). Economists at the Institute for Policy Innovation project that ending this tax would result in an annual GDP that is $117.3 billion (0.9 percent) above the baseline and the creation of nearly 236,000 more jobs than in the baseline.10

Heritage Foundation analysts estimate that, by 2012, the permanent repeal of the death tax this year would:

  • Add $14.7 billion (adjusted for inflation) to the GDP;
  • Add 118,000 jobs to the U.S. economy; and
  • Raise U.S. personal disposable income by an inflation-adjusted $11 billion.
Ending the Double Tax on Social Security Benefits

At this point, there is not much economic evidence regarding the damage caused by the double tax on Social Security benefits, but it is safe to state that repealing it will yield benefits. While those benefits may be modest compared to the benefits of repealing the death tax and eliminating the double tax on dividends, they should not be ignored.

The double tax on these benefits is anti-growth because it falls on a senior citizen's non-Social Security income, given that the tax takes effect only if a Social Security recipient has a certain level of income from either providing labor or providing capital to the market. The tax burden on that behavior is high. The senior citizen is subject not only to regular tax rates, but also to the added tax burden that results from categorizing additional Social Security benefits as taxable income. Since the tax on Social Security benefits results in a high marginal tax rate for people with incomes above the threshold, this translates into a very high marginal tax rate on productive behavior.

Additional Benefits of the President's Tax Plan

A few other features of the Bush tax plan also are worth discussing--particularly with regard to the positive consequences of eliminating the double tax on dividends. Specifically, the President's plan would:

  • Make America more competitive
    The Bush plan would boost U.S. competitiveness abroad. According to a Cato Institute survey, only three of the world's 30 developed nations--America, Switzerland, and Ireland--impose a double tax on corporate income. Given that Switzerland and Ireland have much lower corporate tax rates, this means that America may have the most punitive and anti-growth dividend tax in the industrialized world.

    This is an embarrassment, and it clearly puts America in a disadvantageous position. About one-fourth of the nation's competitors impose no double taxation on dividends, while almost all the rest have policies that provide at least partial protection from double taxation. Only Japan--which is hardly a role model--has a top dividend tax rate above America's.

  • Help Americans build wealth and save for retirement
    Another benefit of eliminating the double tax on dividends is an increase in wealth. The value of a financial asset is determined by how much after-tax income an investment will generate over time. Removing the second tax on dividends would increase that future income flow and therefore help the stock market. Financial experts say the stock market could expand by about 10 percent under the Bush plan, boosting national wealth by nearly $1 trillion--welcome news for workers who have watched their IRAs and 401(k) accounts shrink.
  • Improve corporate governance
    The Bush plan holds promise for several additional benefits. Under current tax law, for instance, companies are encouraged to use debt, not equity, to finance investments. Why? Because dividends are taxed twice and interest on corporate bonds is taxed only once. If the President's plan is approved, this bias disappears and companies will have a strong incentive to strengthen their balance sheets. This would mean fewer bankruptcies.

    The current tax code also creates a perverse incentive for companies to hoard earnings. Why? Because the double tax on the earnings they keep (capital gains) is lower than the double tax on the earnings they distribute (dividends). 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. This would improve corporate governance, since firms no longer would feel as much pressure to boost share prices by making unwarranted claims about future revenue. Instead, investors would judge a company by the amount of hard cash it pays its shareholders.

Conclusion

The Internal Revenue Code imposes two layers of tax on corporate income. Companies must pay a 35 percent tax on profits. If the remaining after-tax income is then distributed to shareholders, it is subject to another layer of tax since individuals must include dividends in their taxable income. Depending on an individual's tax rate, the effective tax rate on corporate income can exceed 60 percent--and even more once state and local taxes are added to the mix.

The Administration proposes to end the double taxation of dividends by allowing individuals to "exclude" dividends from their tax return while preserving the current 35 percent corporate tax that is imposed on this income. The President's plan recognizes that dividends are after-tax payments and puts an end to the discriminatory and unfair practice of making individuals pay a second layer of tax on this income.

Eliminating the double tax on dividend income will increase growth by dramatically lowering the effective tax rate on business equity investment. President Bush understands that economic growth is the first priority. His plan to eliminate the double tax on dividends is a bold and visionary step, and it is part of an overall economic plan that will make our nation stronger and improve the living standards of all Americans.

Daniel J. Mitchell, Ph.D., is McKenna Senior Fellow in Political Economy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation. This paper is adapted from testimony presented at a hearing held by the U.S. Senate Special Committee on Aging on February 11, 2003.


1. The White House, "Taking Action to Strengthen America's Economy," undated talking points.

2. For more on the economic effects of federal double taxation of dividends, see James M. Poterba, "Tax Policy and Corporate Saving," Brookings Papers on Economic Activity No. 2, 1987, pp. 455-515; Peter Birch Sorensen, "Changing Views of the Corporate Income Tax," National Tax Journal, Vol. 48, Issue 2 (June 1995), pp. 279-294; and James M. Poterba and Lawrence H. Summers, "New Evidence that Taxes Affect the Valuation of Dividends," The Journal of Finance, Vol. 39, Issue 5 (December 1984), pp. 1397-1415.

3. For a complete discussion of the imputation credit, as well as other methods for eliminating the double taxation of dividends, see Deborah Thomas and Keith Sellers, "Eliminate the Double Tax on Dividends," Journal of Accountancy, November 1994.

4. See Ervin Black, Joseph Legoria, and Keith Sellers, "Capital Investment Effects of Dividend Imputation," Journal of the American Taxation Association, Vol. 22, No. 2 (Fall 2000), pp. 40-59.

5. Ibid.

6. See James Poterba and Lawrence Summers, "The Economic Effects of Dividend Taxation," National Bureau of Economic Research, Working Paper No. 1353, May 1984.

7. See Serge Nadeau and Robert Strauss, "Tax Policies and the Real and Financial Decisions of the Firm: The Effects of the Tax Reform Act of 1986," Public Finance Quarterly, Vol. 19, No. 3 (July 1991), pp. 251-292.

8. See Jason Cummins and Kevin Hassett, "The Effects of Taxation on Investment: New Evidence from Firm Level Panel Data," National Tax Journal, Vol. 45, No. 3 (1992), pp. 243-251.

9. The numbers provided in the author's February 11 testimony before the Senate Special Committee on Aging were preliminary estimates from the Center for Data Analysis. The numbers cited here are based on a subsequent, more complete analysis by the CDA.

10. Gary Robbins and Aldona Robbins, "The Case for Burying the Estate Tax," Institute for Policy Innovation, Policy Report No. 150, 1999, at http://www.ipi.org/ipi/IPIPublications.nsf/PublicationLookup
FullTextPDF/5B7CF3BC3D05CC5E862567E6001BFFA4/$File/EstateTax150.pdf?OpenElement
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About the Author

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