Capital gains and dividend taxes were both initiated in the early 1970's, by the Democratic Party. Before dividend taxes were enforced, the government made its money through higher aftertax yields, The dividend tax was originally supposed to be a progressive measure, so that the wealthiest paid correspondingly more than the poorest because they had benefited more. At this time, only the wealthy invested in stocks. This is no longer true. Most middle-class people today are investors in the market and they do not have the expensive accountants hired by the rich to shield their investments from tax.
Investing in the stock market has become far more widespread over the last two decades, as 84 million people - representing nearly half of all American households - owning stock. Tax-deferred investment tools such as 401(k) plans and individual retirement accounts (IRAs) have placed millions of Americans who make $60,000 or less per year into the "investor class." Therefore, while the tax was originally intended to eliminate many of the tax breaks to top-income filers, more middle-income filers are paying the tax today.
Because of the dividend tax law, many of the largest corporations in the U.S. have moved away from paying dividends, choosing instead to reinvest earnings in their enterprises, ultimately adding shareholder value in the form of capital growth. Basically, the idea behind this is that if business increases, so does the value of a stock. Investors would capitalize on this growth by selling the stock and paying capital gains tax on the increased value. Because capital gains are taxed at a lower rate than dividends, these investors had a higher after-tax return because they were not doubled taxed.
However, since the stock market crash in 2000, capital gains have been scarce, and stock prices have dropped. Therefore, once miniscule dividends are now generating attractive yield figures. As a result, President George Bush has proposed eliminating dividend tax -- an issue that has caused great debate in the United States.
In January 2003, President Bush revealed his new economic growth package, which proposed to eliminate the double-taxation of dividend income (Mowbray, 2003). Despite $100 billion-plus cost of the supply-side proposal, enough Democrats are likely to support it to give Bush a margin of victory on the high-profile tax cut aimed at helping the "investor class."
Eliminating the taxes people pay on dividend income would have a strong impact on a good deal of the American public. However, while tens of millions of Americans pay dividend tax every year, eliminating it has not gained any political traction until this year.
While Republicans have been supporting investors for years, Democrats are only now supporting what they view as a constituency that could put them back in power. A Democrat pollster recently found that that are now more people who own stocks than hold jobs among the electorate, by a margin of 66% to 53%
Prior to the November elections, two modest tax cuts were pushed through as a show of support for investors. However, eliminating the dividend tax was not even considered, let alone included in the final package. Yet one suggestion from Charles Schwab, a famous Wall Street player to the President heated up the issue.
Schwab suggested to President Bush that the double taxation of dividends should end. Within a couple months, the idea was supported by many of Washington's top officials. Eliminating the dividend tax appeals to many voters so it appears to be a shoo-in.
Currently, dividends are taxed twice, once when a corporation declares profit, and again when the investor gets his cut. For example, is a corporation has $1,000 in profit to pay out in dividends, it would first pay taxes of $350, and then the shareholder would have to pay up to $253 in taxes on his $650 dividend -- meaning the government takes up to 60% of the original $1,000 profit. For this reason, the number of companies paying dividends has declined.
Eliminating the dividend tax is so greatly supported partly in because it benefits all investors, showing little favoritism for the rich. For example, eliminating the capital gains tax would be criticized as a giveaway to the rich. This concept has been attempted many times and has never succeeded. However, eliminating the dividend tax has no such history and is much more likely to happen.
The middle-class and senior citizens largely pay the dividend tax. Approximately half of dividend recipients are in households with less than $50,000 annual income, and more than half of dividend income goes to people over age 65. In other words, Democrats are not likely to oppose President Bush's initiative.
President George Bush's economic plan has proposed the elimination of the dividend tax, causing much controversy over the intention and potential outcomes of this proposal (Paramar Consulting, 2003). As a result, many people have many varying opinions on who will benefit and how, whether this elimination fosters economic growth, and whether the tax should be eliminated solely on the basis of correcting a flawed tax code.
As far as the flawed tax code issue is concerned, it is one of double taxation. Corporations pay taxes on their income. Dividends are a distribution of that same income. However, when distributing it to individual investor, the income is taxed again on personal returns. Thus, the income is taxed twice. However, many people argue that the same taxpayer is not taxed twice, so it cannot be an issue of double taxation.
One problem with eliminating the dividend tax solely on the basis it is a flawed tax is that there are many instances of double taxation that are more influential than the dividend tax. For example, sales tax or gasoline tax doe not really differ in principle from the dividend tax. All Americans pay tax on our income and are taxed again when we spend that income.
Bush claims that, when implemented, the elimination of dividend taxes will stimulate the currently slow U.S. economy. Currently, any money an investor receives when a stock pays a dividend to its investors is added to his or her total income at tax time. Therefore, dividend income is treated the same way, and is taxed at the same rate, as income from employment. If dividend tax is eliminated, dividend income will no longer be added to an investor's total income. As a result the dividends will be exempt from taxation.
The Bush Administration claims that, by eliminating the dividend tax, investors will be encouraged to buy more stocks (Mofatt, 2003). Many economists believe that the elimination of the dividend tax will have the effect of raising the demand and price of stocks, which will cause a rise in the value of the various stock market indices.
Dividend Tax Law as Related to Corporations and Individual Investors
Proponents of the dividend tax elimination say that eliminating taxes on dividends would make dividend-paying stocks more attractive to investors. In addition, they believe that dividend-tax reductions would encourage business investment and push corporations to finance growth by issuing stock rather than borrowing money. Still, many corporations find borrowing to be more tax-efficient because the interest paid is a tax-deductible business expense.
The Bush Administration claims that by eliminating the tax, it expects government revenues to increase as a result of more business activity in the economy. However, while many support the tax elimination, others say that this is another case where a benefit goes only to the "rich" and offers little benefit to the general public. However, since more than half of all U.S. households own stocks in one form or another, this argument is not very substantial.
A more relevant argument against Bush's proposed tax elimination is that it may lead to many unintended consequences. During the 1990s, corporations used their capital to reinvest in businesses, fueling one of the greatest Bull Markets for stocks in history. Without this reinvestment of capital, expansion and productivity may decline.
If stock prices become linked to dividend payouts, corporations many have more incentive to distribute cash as dividends instead of reinvesting, for long-term health and growth, in their enterprises. Corporations may give executives stock-paying tax-free dividends rather than options with potential ordinary income taxation consequences, making the rich richer.
One of the effects of the dividend tax elimination is that companies will have a much greater incentive to give money back to shareholders. Currently, companies' main incentive is to hold onto cash, and to use that cash as the basis on which to take on debt. Companies should always seek the most efficient use of capital, thus returning it to shareholders. Removing a disincentive from making this decision on a tax-neutral basis is important.
Dividends add weight to the stock market. If a company with no dividend falls 70% in share price, it is considered a big risk. While this may not be true, people will still consider it a big risk. "If a company has a dividend yield of, say, 2% at its peak price, suddenly after such a…