Dividend tax policy and economic effects

Dividend Tax

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 drop, its yield is 6.67%. A dividend at this level would thus help attract investors. The current tax regime deters such thinking."

Enhancing dividends as a way to return equity to investors may help corporate governance (Mann, 2003). Many people believe that it would end the practice of share buybacks, except for those companies with ridiculous stock options programs. However, others believe that if management feels shares are the most efficient way to spend cash then the company should buy back shares. However, investors should not just sit on cash without a plan for it, just as companies should not buy back expensive shares just to counteract stock option dilution.

Currently, the bias against dividend distributions is not good for stockholders (Hall, 2003). Dividends used to be the way that corporations would return earnings to individual investors. In the past, many investors relied on a company's record of paying dividends to gauge its financial outlook.

Companies that consistently pay dividends are those that shareholders know for certain is consistently making money, because dividend payments cannot be smoothed over by clever accounting tricks. Corporations paying dividends have to actually make the earnings to have the cash necessary to pay shareholders.

However, due to the current system, most corporations lack shareholder pressure to distribute dividends due to the double taxation of dividends. Some of the most successful companies today, including Microsoft, Dell and Berkshire Hathaway, pay no dividends and are not pressured by their shareholders at all.

This gives corporations a good deal of freedoms to engage in questionable accounting practices. For example, earnings reports can be deceptive because the company does not have to worry about shareholders demanding dividends. In addition, since the bias against dividends means most companies no longer pay them, the lack of dividend payments can no longer act as a red flag to investors.

Basically, dividend tax reform would enable shareholders to demand dividends from corporations with earnings without worrying about double taxation. While this does not mean all companies would begin paying dividends, many would be pressured to do so or at least explain to their shareholders why retaining earnings is in their best interest. This increased governance may improve corporate decision-making as shareholders assume a greater role in the actions of the company.

Eliminating the double taxation of dividends may have other benefits to both companies and the investor, as well, especially in the areas of stock valuation. "A stock price is generally thought to represent the net present value of discounted future cash flows. Dividends provide the market with tangible information on which to base the value of a stock. Absent dividends, however, all cash flows are well off into the future. Investors, therefore, must rely heavily on a corporation's earnings statement to gauge the future profitability of a company. Recent corporate accounting scandals illustrate potential problems associated with relying on earnings statements from companies not paying dividends."

Therefore, stock prices for corporations that do not pay dividends are more sensitive to assumptions, including interest rates, market conditions and unexpected developments. This has greatly increased the volatility of stocks and made many businesses more sensitive to current economic conditions than they would be if they paid dividends to their shareholders. In this light, companies would be better prepared for economic downturns. Because the paying of dividends requires cash on hand, many corporations will be better able to weather recessions than if they were highly leveraged.

Finally, because the government's take of the investment dollar would be smaller, capital formation should increase. Investors would have dividends for new and productive uses. Dividend tax reform seems to be the answer to improving corporate governance in the short run and the economy in the long run.

The cost of double taxation

According to Walker, dividend tax works in this manner: "If the company chooses to pay out the earnings as a dividend, the shareholder gets a check for 60¢, the earnings that remain after corporate income tax. The dividend check being taxable income, the shareholder must pay 24¢ (40% of 60¢) of tax on the dividend, leaving 36¢ of the original dollar earned by the company. Although these numbers will vary depending upon the tax rates paid by the company and the investor, it's clear that with taxes taking 64% of every dollar, operating a company in order to pay revenues out as dividends is a far more effective way of transferring wealth to the government, which ends up with 64¢ from each dollar, than to the shareholder, who's left with 36¢."

Therefore, it seems crazy to even consider paying dividends. However, there are many things to consider. If a business cannot spend its earnings productively (or make enough after-tax earnings to satisfy market expectations), nor has a need for debt which would transfer before-tax earnings to bondholders, payment of corporate income tax is unavoidable.

Once the earnings have been placed on the books, only two alternatives remain: add them to the company's working capital pool or pay them out. According to Walker, "Once the company has amassed working capital adequate for its needs, the shareholders begin to become restive. They demand, and rightfully so, "If you can't think of anything to do with the money other than buy Treasury Bills, why don't you give it back and let us decide how to invest it?." After all, once earnings are reported, payment of corporate income tax is a foregone conclusion. The shareholder does not look at the fraction of pre-tax earnings retained; he sees the after-tax earnings per share reported by the company, multiplies that by his holdings, and begins to think how nice it would be to find a check for that sum in his mailbox, notwithstanding the need to pay taxes on it."

Dividend Tax Other Countries

The proposal tax cut on dividends is touted by many as a necessary means to boost stock market, lessen the tax code bias against savings, and reduce incentives for firms to assume too much debt and retain earnings. In addition, proponents point to the fact that other countries have already taken positive steps towards eliminating dividend taxes and the U.S. must do the same.

A review of tax policies in 30 industrial countries reveals that nearly all major nations provide partial or full relief of dividend double taxation. The table below summarizes dividend tax policy for nations in the Organization for Economic Cooperation and Development, based on data from the OECD, Ernst & Young, and various country-specific sources. This shows that many countries utilize various methods to provide dividend tax relief, including providing individuals a tax credit that either fully or partially offsets the double taxation of dividends. Countries currently offering partial tax credits include Canada, France, and the United Kingdom. Australia, Finland, Italy, Mexico, New Zealand and Norway offer full credits. In Norway, the combined corporate and individual top tax rate on dividends is just 28% -- less than half the U.S. top rate of 60%.