Corporate earnings distributed as dividends may face both the 35 percent corporate income tax and the individual income tax, which has a top rate of 38.6 percent. This “double taxation” leads to a combined marginal tax rate of up to 60 percent on dividends. By contrast, interest is deductible to the corporation and thus only faces taxation at the individual level. A review of tax policies in 30 industrial countries finds that nearly all major nations provide partial or full relief of dividend double taxation.
Table 1, 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. The survey found that a variety of approaches are used to provide dividend tax relief.
Individual credit. A dozen OECD countries provide individuals a tax credit that either fully or partially offsets the double taxation of dividends. Countries offering partial tax credits include Canada, France, and the United Kingdom. Countries providing credits that fully offset double taxation include Australia, Finland, Italy, Mexico, New Zealand and Norway. In Norway, the combined corporate and individual top tax rate on dividends is just 28 percent–less than half the U.S. top rate of 60 percent.
Reduced individual tax rate. The most common form of dividend tax relief is providing a tax rate on dividends that is lower than the top ordinary rate on wages. About half of OECD countries have a lower, often flat, tax rate on dividends, including Austria, Belgium, the Czech Republic, Denmark, Iceland, the Netherlands and Poland. Some countries, including Finland, Norway, and Sweden, have “dual income tax systems” that impose high rates on wage income, but lower flat rates on capital income, including dividends and capital gains. (Table 1 shows the maximum tax rate on dividends for countries where the dividend tax rate is lower than the ordinary top rate).
Individual exclusion. Two countries, Germany and Luxembourg, offer a 50 percent dividend exclusion to individuals. That means that if a shareholder receives $1,000 in dividends, $500 would be tax‐free. Greece fully exempts domestic dividends from individual taxation (a 100 percent exclusion).
Corporate deduction. Dividends can be given parallel treatment to interest by allowing corporations to deduct dividends at the corporate level. The Czech Republic and Iceland allow corporations to partially deduct dividends.
No double taxation relief. Only Ireland, Switzerland, and the United States do not offer relief from dividend double taxation among the 30 OECD countries. However, corporate income tax rates in Ireland and Switzerland are just 12.5 percent and 24.5 percent, respectively, with the result that dividends face a lower overall tax burden in those countries than in the United States.
Clearly, the United States is out of step with the comparatively pro‐growth dividend tax policies of other nations. Foreign policymakers have figured out that high dividend tax rates damage the economy by creating numerous distortions. First, high dividend taxes add to the income tax code’s general bias against savings and investment. Second, high dividend taxes cause corporations to rely too much on debt rather than equity financing because interest is deductible against the corporate income tax but dividends are not. Highly indebted firms are more vulnerable to bankruptcy in economic downturns. Third, high dividend taxes reduce the incentive to pay out dividends in favor of retained earnings. That may cause corporate executives to invest in wasteful or unprofitable projects. Also, it is harder for investors to accurately value firms when they do not receive a regular hard cash dividend stream. Fourth, high and uneven tax rates on dividends and other types of capital income greatly increase financial engineering efforts to avoid taxes, which ends up wasting resources and confusing investors.
President Bush’s dividend tax proposal would go a long way toward fixing these serious problems in the federal tax code. Reform is long overdue because the United States substantially overtaxes dividends compared to other countries. U.S. shareholders deserve much better treatment, and it is now up to Congress to deliver it.