Dividends and Debt

This article orignally appeared on on September 12, 2002.

Last October, I wrote “Wartime Economics Then and Now,” noting similarities between the recessions of 1990 and 2001. I did not imagine the similarities would come to include the chance of a second war in Iraq.

Then and now, the administration emphasized foreign affairs while the economy was struggling to get back on its feet. Although the first Iraq war was more popular than the proposed revisit, presidential inattention to the domestic economy nonetheless proved politically suicidal for Bush 41. Hopes of avoiding that particular similarity led to last month’s economic summit. But words never substitute for results.

Soon after Bush 43 praised summiteer Charles Schwab’s proposal to cut the double taxation of dividends, various other trial balloons were floated about tax changes kind to suffering investors. Unfortunately, as political columnist John Harwood noted, “Congress appears little interested in new tax breaks for investors that Mr. Bush has halfheartedly embraced.”

Halfhearted or not, the president’s apparent support for policies to help investors made more sense than last spring’s policy of assigning top priority to ephemeral rebates. Like any bundle of tax proposals, however, some would lose revenue without much impact on incentives or efficiency. Besides, too many details steal attention from the indispensable centerpiece of the plan — reducing the double taxation of dividends. If that infamous tax injustice had been fixed a few years ago, the nation’s recent string of giant bankruptcies might well have been avoided.

Profits are first subject to a corporate tax of 35 percent, and then individual stockholders pay a second tax of 38.5 percent on any leftover earnings paid out as dividends. Every dollar of profit shrinks to 40 cents to the stockholder, even before state taxes take two more bites.

Corporations minimize this double tax by taking on risky levels of debt and thus taking big deductions for big interest expenses. Many avoid the double tax by not paying dividends, and instead reinvesting earnings in sometimes dubious ways. Both tax distortions came together in Enron and WorldCom, which augmented retained earnings with tens of billions of dollars of debt to generate rapid growth through acquisitions. It was bad debt that did them in, not bad bookkeeping. But bookkeeping would become less contentious if dividends were taxed more fairly, because there is no way to conceal the inability to pay an expected dividend.

If the tax on dividends had been reduced to 20 percent in 1997 (as it was on capital gains), investors would have favored companies with goods prospects of paying dividends. They would have been far more leery of Enron-like “growth stocks” that mortgaged many years of future income, leaving no hope of dividends.

The best long-term policies happen to be the best short-term stimulus. Because investors and companies base investment plans on future prospects, policies that improve the long-term outlook promise immediate gains for the economy’s weakest links — the stock market and business investment. By raising stockholders’ expected after-tax return, reduced taxation of dividends will give an enormous and enduring lift to the stock market. And that, in turn, will greatly increase household wealth, and make it cheaper and easier for firms to raise capital by selling shares rather than getting deeper in hock.

The president’s advisers are rumored to be timid doves when it comes to domestic policy. Some are even said to be easily intimidated by the opposition’s careless claims that lower taxes on dividends would lose a lot of tax revenue and unduly benefit the rich. Both claims completely ignore how easily the dividend tax is avoided by corporations that refuse to pay dividends and by individuals that refuse to hold dividend-paying stock in taxable accounts.

Individuals in the top tax brackets typically shun dividend-paying stocks in favor of tax-exempt municipal bonds, real estate and investments expected to yield interest income (labeled “dividends” when it is from a bond fund) or capital gains. As a result, many dividend-paying shares end up in tax-deferred pension funds and tax-exempt foundations.

If stock dividends were taxed at 20 percent, there would be billions more dividends to tax. And millions of dividend-paying shares now sitting in tax-exempt institutions would be acquired by “rich” individual investors, meaning the second tax on those dividends would rise from zero to 20 percent.

Because stocks previously held by tax-exempt pension funds and foundations would be sold to individuals now willing to pay a reasonable tax on dividends, and because dividends would be much more common and generous, actual taxes paid on dividends — particularly by the rich — would rise, rather than fall.

If federal bean-counters who estimate tax revenues and income distribution cannot figure this out, then fire the bean-counters. If the president’s advisers cannot figure this out, then fire the advisers. And if some members of Congress cannot figure this out, then voters should fire them, too.

Alan Reynolds is a senior fellow with the Cato Institute. To find out more about Alan Reynolds, and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate Web page at

Alan Reynolds is a senior fellow with the Cato Institute.