On April 30, Congressman Bill Thomas, Chair of the House Ways
and Means Committee, proposed reducing the personal income tax rate
on long-term capital gains and dividends to 5 percent for filers in
the 10 and 15 percent individual income tax bracket and 15 percent
for filers in the higher tax brackets. This proposal could be a
compromise between President Bush's plan for full repeal of the
double taxation of dividends and the Senate's less substantial tax
cut package. Chairman
Thomas's proposal aims to give a spark to the economy by
substantially reducing the cost of capital for a price tag that
should please the Senate.
Reducing the taxes on capital gains and
dividends causes economic growth by reducing the cost of
investment. CDA economists
estimate that the 5/15 proposal could provide an immediate boost to
This proposal could create 252,000 jobs in
2004 and an average of 367,000 new jobs from 2004 to 2008.
Furthermore, real GDP would increase by
$21.0 billion in 2004 and an average of $30.9 billion from 2004 to
The stronger pace of economic activity
expands the pool of income from which taxes are drawn and reduces
the ten-year reduction in federal revenues from an estimated $277
billion to $147 billion. This is an economic feedback of 49
CDA economists estimate that for every
additional dollar of federal debt, personal income will grow by
What factors explain this boost to economic
growth? Potential investors
will be more willing to invest because they will pay less tax on
the returns to their investment. Also, corporate managers will find
it more profitable to invest in projects that they previously
decided against undertaking since their cost of capital will
decline. Both investors' and
managers' actions will boost the economy because their costs have
dropped and potential profits have increased.
Firms' cost of capital will decline because
lowering the tax on dividends and capital gains makes it easier for
managers to return money to investors. When investors buy stock, they
expect to receive dividends and/or capital gains. The dividends and capital gains
that companies have to provide to investors, therefore, represent a
part of the firms' cost of capital.
Therefore, lowering the taxes on dividends and
capital gains lowers firms' cost of capital. In a recent CDA report, for
instance, we estimated that lowering the tax rates on dividends and
capital gains would have reduced Idexx Labs' (a public corporation
based in Maine) cost of capital by about 4 percent. In other words, lowering taxes on
capital lowers the cost of doing business and undertaking new
addition, the 5/15 plan remains neutral with respect to how
companies distribute their profits.
With the tax rate of capital gains and dividends the same,
companies will not be penalized for choosing to return profits in
the form of dividends rather than capital gains (or vice versa).
For this reason, companies
will realize a uniform reduction in their cost of capital. Over time, these effects of
lowering the cost of capital lead to higher economic growth and
widespread economic benefits.
Norbert J. Michel, Ralph A. Rector and Alfredo Goyburu, "How The
President's Dividend Plan Would Increase Corporate Investment,"
Heritage Foundation CDA Report, CDA03-07, April 30, 2003, at www.heritage.org/Research/Taxes/CD0307.cfm
long as the managers act in the best interest of their
shareholders, this relationship holds for all firms with existing