Should the individual tax on dividends be eliminated?
Overview/BackgroundWhen corporations earn an annual profit, they must pay a corporate tax to the government. However, when the remaining corporate profit is distributed to the individual shareholders, it is once again taxed. Thus, you have in effect a "double taxation" of the same income. President Bush was able to drastically reduce the rate of taxation on dividends. However, his dividend tax cut is only temporary and some say it should be eliminated altogether.
- It would lead to more responsibility in the accounting and administration of corporations. We have been hit with a barrage of corporate scandals in the recent past--Enron, Tyco, Worldcom, and so on. Billions of investor dollars have been lost, and confidence in the corporate world is very low, which contributed heavily to the last recession. We are finding out more and more how easy it is for corporations to dupe investors by manipulating accounting numbers to give the appearance of greater profits and wealth. Generally Accepted Accounting Principles, or GAAP, is a complicated system that leaves a lot of room for interpretation. Stock investors make money in two ways--one, through gains on the sale of the stock, and two, dividend income. Most tech companies and those hit by scandal have focused on putting up good accounting numbers so the price of stock would go up; they have focused less on paying dividends. In fact, most tech companies don't pay dividends at all. By cutting the individual tax on dividends, this focus on stock price would start to change. Investors would demand more of the profits be paid out in cash dividends. Since managers would have to ensure a steady supply of cash, they would have to put more effort in generating cash, which all for-profit businesses should be doing. Also, it's much more difficult to hide and manipulate cash flow. Thus, businesses would start to emphasize tangible cash flow results rather than meaningless paper income and balance sheet numbers.
- Retirees and others living on fixed incomes would have more take-home pay. Over 50 percent of seniors in this country currently receive some form of dividend income. Cutting the individual dividend tax would increase their disposable income and supplement a social security system which pays out poverty-level amounts.
- It would stimulate more investment in the stock market, along with great business investment spending. Americans have a lot of money to invest; much of this money is in investments such as bonds, savings accounts, CDs, T-bills, and money market accounts. However, most of these safer investments offer low returns and are taxed. By removing the dividend tax, investors would start moving that money into stocks (since the risk-return ratio would be reduced significantly). First of all, this infusion of capital would give corporations funds that could be used for investment and expansion, leading to more economic growth and jobs. Second of all, the movement of money into the stock market would cause 401(k) and other portfolio balances to increase substantially. You could argue that the last economic slowdown was one of confidence. Individuals are less willing to spend and invest when their savings are so perilously low. If people see their retirement account balances recovering, they are more likely to go out and buy a car, take a trip, start a new business, etc. Why do you think "Consumer Confidence" numbers are so often quoted in the financial press? And with the stock market indices returning to higher levels, businesses won't be so squeamish about investing and expanding.
- More money in the hands of consumers means more money can be spent to get the economy going. Whenever you have a tax cut, the money doesn't suddenly disappear into thin air. The money simply goes to someone else; in this case, it would be the individual taxpayer. We are a consumer-spending driven economy. When individuals have more take home pay, they have more money to spend on computers, home improvements, cars, etc. This is just what we need to put more steam into the economy.
- It makes the expansion of small businesses easier. Businesses much choose a form of legal ownership for their operation. Among the many choices are partnerships, limited liability companies, and corporations. Each form of ownership has its advantages and disadvantages. The biggest disadvantage of a corporation is the double taxation of income. Many businesses will delay or avoid altogether the forming of a corporation for this specific reason. Unfortunately, the best way to raise funds for expansion and investment is through the sale of corporate stock shares. Whereas it may be next to impossible to find two investors to invest $500,0000 each, it may be easy to find 10,000 investors to invest $100 each. Cutting the double taxation of dividends would therefore eliminate the main disadvantage of the corporate form of ownership. Big businesses often get a bad rap in this country, but let's not forget that big corporations are able to use the economics of scale to achieve greater efficiency; they provide a number of valuable goods and services; and they are the main source of jobs. For example, Wal-Mart alone employs hundreds of thousands of workers around the world. Eliminating the double taxation would remove this obstacle to growth.
- Consumers & private investors know how to handle money better than the government. Can you think of one single government service that's provided efficiently? The DMV? The Social Security Administration? Virtually everyone has a horror story of dealing with government waste and bureaucracy. Over 73 cents of every dollar set aside for welfare goes for administrative costs. Only in America can the government buy a hammer for the bargain price of $800. Entire books have been written on government waste. Who do you think would do a better job of getting value for their dollars--individuals or the government? Who do you think should decide where the money is spent--individuals or the government? The fact is that almost any tax cut is good for America. Remember, the money is not disappearing into thin air; it's simply being put in the hands of someone else--the people who have earned it.
- Most of the tax savings will be going to the wealthy. With much of America struggling, personal debt growing, and savings accounts dwindling, we have to question whether we want to cut taxes for the people that have the fewest financial problems. In order to receive any significant dividend income, you have to have a lot of money already invested in stock. People working minimum wage jobs and living paycheck to paycheck aren't going to have much money invested in stock (if any). This tax cut will in effect mostly benefit those that don't need the money.
- It discourages the investment of stocks in retirement accounts. Most of the stock wealth in this country is concentrated in 401(k), IRA, and other retirement accounts. Dividend income is already tax-free in these accounts. Thus, the dividend tax change would only affect investors who held stock outside of retirement accounts. In fact, it will likely create an incentive to shift retirement fund allocations from stocks to bonds (because of the risk-return ratio). Therefore, the net increase in stock market indices will probably be negligible. It may also prompt many investors to put less money into the retirement accounts in the first place. Think about it--if you can receive tax-free dividend income in non-retirement stocks where you have total control over your money, why would you put the dollars into a retirement account that is locked in until your 60s? Some people might want the discipline of not being able to touch the money until they retire, but others who want the flexibility to access the money before then will opt for investing in non-retirement accounts. With a social security system on course for bankruptcy within 25 years, do we really want to remove another incentive for retirement savings?
- Companies may slow down capital spending so they can pay out more dividends. The current double taxation of dividends creates an incentive for corporations to retain their earning. That retained earnings is used to finance investment and expansion, leading to jobs and efficiency growth. Eliminating the individual tax on dividends will motivate investors to demand more cash dividends. Removing the cash from the hands of corporations means there could be a slow down in capital spending, or possibly a greater reliance on debt financing. Neither option is appealing.
- Cutting taxes would be risky since we need the money for homeland security, education, and other priorities. We're at a critical point in our history. War, terrorism, crime, failing educational institutions, and other problems demand our constant attention. We have to ask, is this really the best time to be cutting taxes? We are already projected to have record deficits in the coming years (in real dollar amounts rather than as a percentage of GNP). Cutting taxes will likely increase those deficits. Ronald Reagan massively cut taxes in the 80s. Although revenues eventually doubled due to the economic expansion, there's no guarantee the same thing will happen this time around; and even if government revenues do go up, it will likely take some time for that to happen. In the meantime, deficits will continue to grow, which could lead to higher inflation and interest rates. Right now, there are so many areas where we need to spend money. Homeland security is the most obvious. Cutting the dividend tax is an unprecedented experiment, and a risky one at that.
- There are ways to cut taxes that are more immediately stimulative to the economy. As discussed previously, the dividend tax cut is risky, and it may or may not stimulate the economy. There are better, less risky alternatives that provide immediate benefits. One is to allow an accelerated tax write-off of depreciation. Depreciation tax deductions result from the year-by-year write-off of the cost of capital investments like machines, buildings, and computers. Accelerating these write-offs would create incentives for business to start investing immediately, and the tax paid in would be the same (although the tax revenue would come in at a later time). Other tax cut alternatives include widening the 10 percent bracket or cutting social security taxes. Any extra money in the hands of lower income individuals is likely to be spent immediately in its entirety. Thus, the increased consumer spending leads to economic expansion, without the risk of a dividend tax cut.
- It would raise the interest cost of borrowing for state & local governments. State and local governments around the country are in a major cash crisis, most notably in the states of California and New York. There is no sign of this crisis going away any time soon. An advantage these governments have in borrowing money however is that their bonds are usually tax-free. This tax-free status prompts many Americans in higher tax brackets to buy the bonds. However, if dividends are made tax-free, individuals will start to shift money from these municipal bonds to stocks. With less demand in the bonds, the interest rates will go up, thereby adding to the cash problems of the governments.
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Written by: Joe Messerli
Page Last Updated: 11/19/2011