Dividend Taxation Looks Ready to Return

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On January 1, 2011 much of the existing US personal income tax code will expire. The result would be huge tax increases on American households and business owners totaling $3.4 trillion (including alternative minimum tax) over the next 10 years. Most observers expect Congress to take action to prevent (most) tax increases from impacting middle-income Americans. Indeed, the new statutory pay-as-you-go (PAYGO) law explicitly allows Congress to extend President Bush’s tax cuts for middle-income Americans without having to “pay for” the associated revenue loss. However, PAYGO does not provide such protections for all of the revenue proposals contained in President Obama’s budget. For example, if Congress wishes to prevent dividend income from being taxed at the top ordinary rate – 39.6% starting January 1, 2011 – it will have to offset it with new taxes or spending reductions. (The capital gains rate automatically reverts to its pre-2003 level of 20%).

Since the late 1980s economists have generally agreed that the optimal tax rate on capital income is zero due to the way such taxes distort savings decisions. A major contributor to this line of thinking was Larry Summers, the current White House economic policy adviser. In an influential economic journal article, Summers argued that increases in the after-tax return to savings and investment result in “substantial increases in long run capital accumulation.” Summers’ basic insight was that savings and investment decisions were more sensitive to tax rates than was commonly supposed. Households respond to higher taxes on capital gains, dividends, and interest by consuming more of their income; more consumption and less investment means a smaller economy and lower living standards in the long-term.

Prior to passage of the 2003 tax relief, dividend income was taxed at the recipient’s ordinary income tax rate. This meant that $1 of corporate income was first subject to the 35% corporate income tax and then hit with the additional 35% top personal income tax rate, making the effective tax rate nearly 58%. In addition to discouraging savings, this tax creates additional distortions that, according to the Congressional Budget Office (CBO), “interfere with the allocation of investment” and “leave most people less well off (page 260).” Dividend taxation makes distributing corporate income to shareholders inefficient and costly. This locks money in the corporation and increases the probability that management will squander resources by making investments with lower returns than those available to individual shareholders.

If the government imposes a 40% dividend tax, for example, and shareholders could reinvest dividends in an alternative investment at a 5% rate, shareholders would be better off if the corporation instead used the money to fund a project with a 3.1% return. When capital is allocated to less productive uses due to tax considerations, economic growth is compromised. It’s also about opportunity costs – and the key question is whether the internal rate of return on an investment made by company management would be greater than if the cash was simply paid out to shareholders as a dividend? Given that nonfinancial corporations’ hold $14.29 trillion in liquid assets – roughly equal to US GDP – seemingly minor tax-induced misallocations can have a profound impact on living standards.

The 2003 dividend tax cut has been a success. In its analysis of the President’s Budget, CBO found that the “evidence amassed so far is consistent with the view that dividend taxation affects payout policies” and that the “reduction in dividend taxation in 2003, for instance, was followed by a significant increase in dividends issued.” If Congress does not act, these economic efficiency gains would be compromised by a staggering 164% tax increase. Only $15 of every $100 of dividends received on December 31, 2010 would be subject to tax compared to $39.6 of every $100 received on January 1, 2011. By January 2013, the government would collect $42.8 of every $100 paid out in dividends once the new 3.8% Medicare tax takes effect.

According to the Joint Committee on Taxation (JCT), a permanent extension of the 15% dividend and capital gains rates for households with $250,000 or less in income ($200,000 for single filers) and a new 20% dividend rate for households above this income threshold would cost $238 billion over ten years. While it is unclear how much of this total cost comes from the dividend tax reduction, according to Alan Viard’s analysis of the 2007 personal income tax statistics, households with incomes greater than $200,000 reported 47% of all interest income, 60% of all dividends, and 84% of all net capital gains. Given that Ernst & Young estimates that $155 billion in dividends were taxed at the lower rate for the most recent tax year, it is not unreasonable to suspect that the ten-year cost of a 20% dividend tax rate would be nearly $150 billion.

Viard’s analysis highlights how compelling the tax statistics are to both sides of the capital income tax debate, though for opposite reasons. For market-oriented supporters of low taxes on capital income, the fact that 60% of dividends go to households in the income brackets subject to the new 36% and 39.6% dividend tax rates is deeply troubling because these are the households whose savings and investment decisions are most significant from the standpoint of economic efficiency. These are precisely the households that serve as the marginal savers and purchasers of corporate capital.

Yet, to those for whom public finance questions begin and end with the distributional consequence of a policy change, these tax statistics make an equally compelling case to do nothing. If higher-income taxpayers report a disproportionately large share of capital income, then capital income taxes should be the first category of taxes to be raised. One does not need to look beyond which tax returns would benefit from a perspective change to judge the merits of the proposal.

While the secondary or tertiary economic impacts of raising taxes on capital income may be more difficult to perceive, they are very real. Finding $150 billion of mandatory spending reductions to limit the damage from higher dividend taxes would be worth every penny in terms of increased private sector output and job growth. But given the recent decision to raise taxes on investment income by 3.8% as part of the new health care entitlement, Democrats seem to be more interested in the character of the taxpayer than the character of the income.