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WebMemo #270 on Taxes

May 6, 2003

Lowering Dividends and Capital Gains to 15 Percent Creates Significant Economic Growth

By , and

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 the economy.

  • 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 2008.
  • 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 percent.
  • CDA economists estimate that for every additional dollar of federal debt, personal income will grow by $3.37.

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.[1] In other words, lowering taxes on capital lowers the cost of doing business and undertaking new activities.[2] In 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.

[1] See 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.
[2] As long as the managers act in the best interest of their shareholders, this relationship holds for all firms with existing equity capital.

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