Dividend and Conquer

The big dog of the legislative calendar this year is President Bush’s new economic growth and jobs package. And, at the center of this tax relief plan is the repeal of the dividend tax, which will return over $300 billion to Americans over the next ten years.

It’s big, and it’s bold, and news that President Bush wants to completely repeal the tax on dividend income came as something of a shock. People asked, what the heck is the dividend tax anyway?

Good question. Currently, dividends are taxed once as part of corporate earnings, and again as the personal income of the investor who receives the dividend. This double taxation creates an effective tax rate that can approach 60 percent. No wonder that as a result, firms paying dividends have dropped from 66 percent in 1978 to 21 percent in 1999, according to the American Shareholder Association. This double taxation also punishes investment and discourages capital formation and jobs creation.

Double taxation is clearly bad policy, but other observers were surprised Bush went for total repeal. But, Bush was right on target. Proposing only a 50 percent repeal, as we originally heard might happened, would be a feeble half measure. A 50 percent repeal leaves plenty of room for Congress to play games and sock it certain groups of dividend earners. The result of a 50 percent repeal: a tax code that is MORE complicated than before, and less fair.

So, completely repealing the dividend tax is therefore excellent public policy and represents the first tax reform since 1986. Bush seems in control, focusing on the principles and benefits of repeal to the economy, while everyone else seems confused and defensive and lacking their own ideas. That’s why the initial response from the Washington interest groups is all over the map.

Of course, among Democrats, the response was predictable: class warfare and general hysteria. The Democrats immediately began hollering about favoring the rich, and Nancy Pelosi said the Bush tax plan sent America “careening off the road recklessly.”

Many state governments also hate the repeal of the dividend tax, because it undermines their tax revenues, which track the federal dividend tax in 37 states. The National Association of Governors whines that dividend repeal will cost states a total of $4 billion annually in lost taxes. That’s a problem as states continue to overspend like it’s 1999. Greedy states might even add surcharge taxes on dividends, undermining the positive benefits of the Bush plan. But, all governments like taxes, so the state response is fairly predictable.

More unusual is that even the business lobby is pretty lukewarm on the plan. What corporate America really wants is more breaks on new investment, or an end to taxes on money earned overseas. These are good policies, too, but Bush had to make some choices. After Enron and Worldcom, the corporate community isn’t exactly getting a lot of sympathy from the American public. Thus, Bush focused on the dividend repeal, because dividends are taxed on individuals’ tax returns.

And what about mainstream America? As Salon Magazine’s Scott Rosenberg put it, “Now, there isn’t exactly a mass movement to repeal the dividend tax. You don’t see too many street demonstrations or write-in campaigns in which an impassioned citizenry vents anger at its injustice.”

Not yet, anyway.

That’s because the more Americans learn about the Bush dividend proposal, the more they like it. CSE just completed national polling on the different elements of the Bush tax plan. The poll was conducted by the objective Tarrance Group and has a margin or error of 3.1 percent. When registered voters were told:

“The plan would eliminate the double taxation of dividends for stockholders. This means that dividend payments made to individuals would not be counted as taxable income.”

62 percent of voters said it would make them more likely to support the President’s plan.

Further, when told:

“With the new plan, seniors would get over half the tax relief resulting from the elimination of the taxation on dividends.”

75 percent of registered voters said it made them more likely to support the plan. In terms of moving people on an issue, a 75 percent favorable response rate on a neutral statement of fact is a political grand slam.

The political geography of dividend repeal is also worth a look. According to an analysis from the non-partisan Tax Foundation, the top five states with dividend claims in 2000 were California ($18.7 billion), New York ($12.3 billion), Florida ($11.9 billion), Illinois ($7.1 billion). and New Jersey ($5.9 billion). With the exception of California, these will all be 2004 battleground states.

Repealing the dividend tax also makes political sense if you look at two groups of beneficiaries: senior citizens and the investor class.

Seniors really benefit, in part because many of them are wealthy investors, and in part because a significant number of seniors rely on the steady stream of dividend income in their retirement. All told, almost one half of the savings from the dividend tax repeal would go to taxpayers 65 and older. That works out to an average of tax break of $936. (However, the White House hasn’t reported the median tax break—this average number might not be completely representative.)

The investor class has taken a real beating in the market over the past three years. Repealing the dividend tax should produce some lift to the market as a whole, especially for stocks of companies that pay a lot of taxes. It’s tough to quantify this effect, though, because so many factors move the market.

For investors, there’s also the issue of corporate management. The dividend tax creates incentives for companies to carry heavy debt burdens instead of issuing more equity, because interest payments on debt are deductible while dividend returns on equity are taxed. What’s more, the dividend tax encourages corporate managers to pump up stock prices with buybacks and retained earnings, instead of issuing dividends. Yet, in financial accounting, cash is king—it’s a lot harder for cheating corporate executives to issue cash dividends than it is to create fictitious retained earnings. Pressure to produce dividends is good discipline for corporate America.

A final corporate argument is simply the principle that all investments should be treated equally. Currently, the dividend tax creates a bias towards partnerships and limited liability companies, because those investments aren’t subject to the dividend tax.

The repeal of the dividend tax is sound economic and tax policy, and elected officials of both parties should feel comfortable supporting the Bush plan. As Democrat candidate Jimmy Carter told Fortune magazine in 1976, “We presently tax corporate income when it’s earned, and we also tax dividends to shareholders. I would favor taxing income only once.”

This principle of fairness and efficiency that Carter describes is up for debate once again. It’s time to take action once and for all. Our tax code should treat all people fairly, and it should not tax income twice. It’s going to be a tough fight against the class warriors in the Senate, but President Bush is right to repeal the dividend tax.