Commentary

Stalked by Fears of Dividend Tax Cuts

This article originally appeared in the Washington Times on December 29, 2002 and in the New York Post on December 30, 2002.

Of all the tax proposals the White House has floated for next year, the one that frightens Democrats the most is cutting the individual tax on dividends to 20 percent or zero. Although objections are obscured with economic gobbledygook, the real worry is political. Some 85 million investors — seniors, in particular — will be ecstatic about relief from the double taxation of stockholder dividends. And they are likely to express their gratitude by voting Republican for years to come.

A preview of how Democrats hope to ward off this threat was recently provided by Allan Sloan, Newsweek’s Wall Street editor. Mr. Sloan began by defining the effectiveness of “economic stimulus” by the sheer volume of money the government has to borrow. This Keynesian confusion allows him to dismiss cutting the dividend tax for the hilarious reason that it is too cheap: “Personal taxes on [stocks and stock mutual funds] amount to only about $25 billion a year, because many corporate dividends go to tax-exempt stockholders.”

Because “many corporate dividends go to tax-exempt stockholders” — pension funds and foundations — figures purporting to show that the rich would pay less in taxes with a lower tax on dividends are simply wrong. Because “many corporate dividends go to tax-exempt stockholders,” taxing other dividends at 20 percent would mean high-bracket taxpayers would hold more stocks in taxable accounts and less in tax-exempt accounts, so the illusory revenue loss of $25 billion would likely turn out to be a revenue gain.

When the tax on capital gains was reduced in 1983-84 and 1997, revenues grew much more rapidly than expected. The same will happen when the dividend tax is cut. Yet by Mr. Sloan’s reasoning, only a tax cut that bleeds the Treasury can possibly provide any “economic stimulus.” By this standard, he would have to argue that cutting the capital gains tax was actually a tax increase in disguise.

His enthusiasm for wasting the most money possible leads Sloan to argue for a one-year tax holiday on the first $10,000 of payroll tax: That “$101 billion windfall would be spent quickly, particularly by lower-income households.” You are not supposed to ask where that money comes from. It would be borrowed from people who would then have $101 billion less “money in their pockets” and $101 billion more in government IOUs for taxpayers to repay.

The scheme has three other drawbacks:

  1. Many lower-income households would reach old age with smaller Social Security checks because benefits are linked to taxes paid.
  2. Social Security would go bust even sooner if $101 billion were stolen from the “lock box” Democrats used to fret about.
  3. President Bush’s critics would have to abstain from quoting economist Joel Slemrod’s study showing that the foolish 2001 rebates — like this newly proposed “windfall” — did not provide even a temporary boost to the economy.

Mr. Sloan admits that “cutting dividend taxes would boost stock prices sharply,” but he measures that effect only in terms of one year’s revenue loss — as though the stock market cannot discount future tax savings. Even on Mr. Sloan’s myopic calculations, cutting the dividend tax to zero would raise stockholder wealth by $624 billion. Presidential adviser Glenn Hubbard estimates a $1.7 trillion boost in stock values. Neither figure is small change.

Mr. Sloan also admits that overtaxing dividends gives companies a “predisposition to borrow” — an important explanation of unsettling bankruptcies, from K-mart to Conseco. Yet, Sloan says, “the way to solve that problem, as Sen. John S. Corzine (former co-head of Goldman Sachs) says, is to make dividends deductible to companies. Not by making dividends tax-free to recipients.”

Given the author’s partisan sources (the Brookings Institution and Mr. Corzine, a New Jersey Democrat), this is fascinating. It hints that Democrats are about to come out in favor of cutting dividend taxes for big business, rather than individuals. Unusual as that would be, it makes political sense. Since Republicans came up with the idea of giving this tax break to individuals, voters are likely to give them credit in any case. If Democrats instead propose channeling the tax breaks to politically generous corporations like Goldman Sachs, that could result in more campaign booty for their party.

Politics aside, giving dividend tax breaks to corporations rather than individuals suffers two fatal flaws:

  • First of all, if corporations deducted dividend payments, then a large portion of the tax benefit would go to foreign investors. If the tax break is confined to U.S. individuals, only Americans benefit.
  • Second, if corporations deducted both interest and dividends paid, many might never again face any significant corporate tax. With the prospect of little or no taxable income for years, many corporations might never be able to fully depreciate or expense the cost of investments in new plant and equipment. Companies cannot write off the cost of a new machine or building if they have no taxable income, after deductions, against which to claim that writeoff. That means Mr. Corzine’s alternative to the president’s plan could seriously weaken the economy’s weakest link — business investment.

The Sloan-Corzine-Brookings plan for dividend taxes is one trial balloon that all the hot air in the world could never lift off the ground.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.