May 9, 2003 | Executive Memorandum on Taxes
Senate Dividend Plan Fails to Deliver for the Economy
all tax cuts are created equal. Some tax cut proposals will
generate more growth by reducing tax rates on work, saving,
investment, and entrepreneurship. However, others will have little
or no impact on the economy because they merely transfer money from
the pockets of one group of people to the pockets of another group.
This is why some tax cuts--such as the Kennedy tax rate reductions
in the 1960s and the Reagan tax rate reductions in the
1980s--yielded big rewards. This also explains why some tax
cuts--such as the Ford tax rebate in the 1970s and the child credit
today--have no effect on the economy's performance.
This analysis also applies to specific issues, such as the
taxation of dividends. Under current law, dividend income is taxed
two times, once by the corporate income tax and a second time by
the personal income tax. There are a number of proposals to address
this double taxation, but not all of them will result in equally
large benefits. Three major proposals are being considered in
- President George W. Bush's proposal would
eliminate the double tax on dividend income by sparing individual
taxpayers from paying income tax on dividends that were already
taxed at the corporate level. It also would eliminate the capital
gains tax on re-invested corporate earnings.
- The House Ways and Means Committee's
proposal would reduce the double tax by lowering the tax rate on
dividend income to 15 percent--a significant reduction. The 15
percent rate would also apply to capital gains, which is another
form of double taxation in the tax code.
- The Senate Finance Committee's proposal
would allow people to protect the first $500 of dividends from
double taxation. Above $500, a small percent of dividend income
would be excluded from taxation, but even after a five-year
phase-in, 81 percent of dividends above $500 would continue to be
every possible measure, the President's plan is the best
alternative and the Senate Finance Committee's plan is the worst.
Indeed, because it would have so little beneficial impact--and
therefore discredit the arguments for good tax policy--current law
is probably preferable to the Senate plan. According to the
following criteria of good tax policy, there is almost no reason to
consider the Senate plan:
incentives to invest more
If something is taxed, less of it is produced. Double
taxing something compounds the damage so that even less is
produced. This is why the double tax on dividends has such an
adverse impact on investment. The President's plan solves this
problem. The House plan substantially reduces the double tax, but
81 percent of dividends would still be subject to double taxation
under the Senate plan, ameliorated only slightly by the 10 percent
to 20 percent exclusion. (In other words, 81 percent of dividends
would still be double taxed under the Senate plan, and affected
taxpayers would pay a second layer of tax equal to 80 percent of
their marginal tax rate; i.e., a taxpayer in the 35 percent tax
bracket would pay a 28 percent tax on dividend income.)
incentives to use capital more efficiently
The double tax on dividends creates incentives for investors and
corporate managers to make decisions based on tax considerations
instead of economic considerations. The President's plan largely
solves this problem. The House plan substantially reduces this form
of social engineering, but the Senate plan does almost nothing to
reduce the tax code's back-door industrial policy.
Current tax law contributed significantly to corporate
scandals because both investors and corporate managers faced a
perverse incentive to overstate projections of future earnings. The
President's plan solves this problem by creating a level playing
field for retained earnings (capital gains) and distributed
earnings (dividends). The House plan also creates a level playing
field, albeit with some double taxation of both dividends and
capital gains. The Senate plan, however, will likely have no
positive impact on corporate governance issues.
The United States is one of only three nations to fully
double tax dividends, and because the U.S. corporate tax rate is
one of the highest in the world, the effective top tax rate on
dividends in America is the second highest in the developed world.
The President's proposal would dramatically improve America's
ranking on this important measure. The House plan would generate a
substantial improvement in the U.S. ranking, but the United States
would see almost no improvement in its competitive position if the
Senate plan were enacted.
Tax cuts could significantly improve the American economy,
but only if lawmakers make wise decisions about which taxes to cut
and how to cut them. Addressing the double tax on dividends is a
big step in the right direction, but the economy will not reap
major benefits unless the tax is reduced the right way.
Mitchell, Ph.D., is McKenna Senior Fellow in
Political Economy in the Thomas A. Roe Institute for Economic
Policy Studies at The Heritage Foundation.