The House of Representatives and the Senate recently passed, respectively, the
Tax Relief Extension Reconciliation Act of 2005 (H.R. 4297) and the
Tax Relief Act of 2005 (S. 2020). The two bills represent the tax
reconciliation legislation of the two chambers, enacted under the
guidelines of their respective budget resolutions.
Despite this common
parentage, the two bills differ significantly on how they
would interact with the economy, thus raising the tax policy stakes
in the conference committee. The Senate bill is filled with
targeted tax cuts and tax subsidies designed to change specific
economic behaviors. Little if anything in the bill would
affect the rate of economic growth. However, the House bill would
take a substantial step toward a stronger economy by
extending the lower tax rates on capital gains and dividend
income for two years.
The lower tax rates are
currently set to expire at the end of 2008. These tax rates help to
reduce the tax code's bias against income that is saved and
invested and have helped to fuel the current robust economic
expansion. The conference committee on these two bills should adopt
the House approach on capital gains and dividends.
Temporary Tax Cuts on
The Jobs and Growth Tax
Relief Reconciliation Act (JGTRRA) of 2003 temporarily reduced the
tax rates on capital gains and dividend income. Proponents of the
tax rate cuts argued that reducing these rates would bolster the
economy by encouraging investment in promising enterprises and
by making dividend payments to stockholders more attractive to
companies. Dividend payouts allow companies to reward their
shareholders in a way other than focusing just on increasing the
Recent data show that
the tax cut proponents' assessment of JGTRRA was right.
Regrettably, Congress has not made these tax cuts permanent and
risks reversing these positive developments. Because businesses
make investment decisions based in part on the taxes that they will
face over many years, it is likely that the prospect of tax
increases after 2008 is already discouraging some of the more
entrepreneurial and risky undertakings. In the jargon of chief
financial officers, the "hurdle rate" (the return on investment
required to permit an undertaking to go forward) will rise to
levels that make some projects untenable.
Businesses are watching
now to see whether Congress will make permanent the first of the
major economic growth components of the 2001 and 2003 tax acts,
extend them, or allow them to expire. Allowing the low tax rates on
investment to expire would signal businesses of all sizes that the
other major pro-growth elements of the Bush tax plan will expire,
undermining the current economic expansion. Thus, Congress
should make the tax reductions permanent, which would:
Bolster economic growth
by reducing the cost of capital,
distribution of dividend payments, and
Make the tax code more
stable and predictable-key elements of good tax
The 2003 Tax Bill
investment slumping in 2001, 2002, and early 2003, JGTRRA focused
on reducing the cost of capital to make investment more
attractive. The resulting lower capital costs allowed
businesses to invest in slightly riskier projects and retire
machines and factories early.
Before these changes,
the tax code did not differentiate between dividend income and
other types of income. Dividend income could be taxed at a rate as
high as 38.6 percent, the highest marginal rate in the tax code.
The average marginal tax rate for dividends was 28 percent, almost
twice the average marginal rate of capital gains of 15 percent.
Taxpayers above the 15 percent marginal tax bracket paid a capital
gains tax rate of 20 percent. Those below the 15 percent
bracket paid a tax rate of 10 percent.
JGTRRA reduced dividend
taxation by treating dividend income like capital gains income.
Both dividend and capital gains income are investment income, which
means that they have already been taxed once as regular income.
JGTRRA sought to reduce the burden of double taxation, which
reduces the incentive to invest.
Because of this tax
bias against dividends, stockholders preferred compensation in
the form of retained earnings (capital gains) rather than
distributed earnings (dividends), and companies shifted toward
capital gains and stock appreciation and away from dividend
payments. The difference in taxation changed the price of capital
for companies and made dividend payments more expensive than
capital gains. As a result, many companies focused too
much on their stock prices, leading to scandals and fraud such as
those involving Enron and Arthur Andersen.
Members of Congress
wanted to give companies another option to reward shareholders
other than increases in stock prices. Taxing capital gains and
dividend income at the same rate gives investors a strong
incentive to seek reliable companies that would pay out earnings in
cash instead of speculative stock gains.
Dividend Payments After
increased after JGTRRA was enacted in the second quarter of 2003.
Some companies responded by increasing their dividend
payout, and 19 other companies instituted a dividend payment
for the first time. Overall, almost 9 percent more companies
paid out dividends after the 2003 tax cut than before the tax
dividends payments to
taxpayers increased from an average of $410 in the second quarter
of 2003 to $518 in the third quarter of 2005-an increase of 24
percent. The overall payout of dividends in 2005 was
over 36.5 percent higher than the payout before the 2003 tax cut.
Dividend income increased by a similar margin after the 2003 cut,
from $750 to $1,000. This is particularly important for
individuals age 62 and over and close to retirement because
dividend payments are an important source of their
A number of studies
point to the dramatic increase in dividend payouts following the
2003 act. Jennifer Blouin, Jana Ready, and Douglas Shackelford
documented significant increases in dividends following passage of
JGTRRA. Others have noted the strong growth in
equity values that stemmed from enhancing the income stream from
stock ownership. Table 1 in the Appendix shows the
distribution of dividend income by state as reported on federal tax
returns for 2003.
Capital Gains After
Chart 1 shows that the
number of Americans reporting capital gains income is clearly
increasing. In 1993, 14.5 million Americans claimed capital gains
income. By 2003, the number had grown to 21.9 million Americans-a
51 percent increase. More important, the percent of all taxpayers
reporting capital gains income increased from 12.6
percent in 1993 to 16.8 percent in 2003.
The 2003 tax cuts
probably contributed to a strong stock market in 2003, which helped
to increase tax revenues on capital gains. The stock market
experienced the second largest percentage increase in the past
decade: The broad-market indexes experienced double-digit
annual growth rates after the 1997 capital gains tax cut and the
2003 capital gains tax cut. This increase in equity
capital helped to finance new businesses and has led to the
increased job growth since the summer of 2003.
In addition to the
economic effects, taxpayers claimed an average of $12,283 in
capital gains income in 2003. As Table 2 shows, this average
varies significantly from state to state. The five states with
the highest averages are Nevada ($28,582); Wyoming ($22,639);
Connecticut ($18,466); Florida ($17,118); and Massachusetts
($17,024). However, the unmistakable feature of Table 2 is the
surprising size of the average in every state. Clearly, gains from
taxable capital investments constitute a substantial portion of
income for the average taxpayer.
It is not surprising,
then, that reductions in capital gains tax rates enjoy
widespread support. In state after state, about one-fifth of all
tax returns contain taxable capital gains. Even in the states with
the lowest percentage of returns showing taxable gains, the
percentage is remarkably high: Mississippi ranks 50th with 10
percent of returns containing capital gains; West Virginia (ranked
49th) shows 11 percent of its taxpayers with taxable gains.
The five states with the highest percentages are Connecticut
(23.4 percent); New Jersey (22.3 percent); Montana (22.0 percent);
Colorado (21.4 percent); and South Dakota (21.1 percent). (See
Table 2 in the Appendix.)
Reducing dividend and
capital gains taxes succeeded in supporting stronger economic
growth and making dividend payments more popular to businesses.
After the tax cut, many companies such as Microsoft began offering
dividend payments or increased their dividend payouts. In
addition, extending these tax rates or making them permanent would
reinforce a central element of good economic policy:
predictable and stable tax law.
Business investment has
grown in every quarter since the 2003 tax cut, in part due to the
reduced cost of capital. The Congressional Budget Office estimates
that the current average taxation of dividends is 12 percent,
but it will become 28 percent if the JGTRRA provisions are
allowed to expire.
In the end, however, it
is not Congress's job to manage the economy or to assume a "leading
role," as old-style European socialists call it, in directing
economic development. Congress's role is to set tax policy that
raises needed revenues for government while interfering as little
as possible with private-sector decision making, which really does
matter to economic growth.
Extending the lower tax
rates on dividend and capital gains income would go a long way
toward fulfilling Congress's basic tax policy
Rea S. Hederman,
Jr., is Manager of Operations and a Senior Policy
Analyst in the Center for Data Analysis, and William W. Beach is
Director of the Center for Data Analysis, at The Heritage
Foundation. The authors gratefully acknowledge the contributions of
J. Scott Moody, who worked on an early version of this paper while
serving as a Senior Policy Analyst in the Center for Data