The debate over double taxation of dividends is rapidly narrowing to a few minor details. There have been the usual dubious complaints that a lower tax on dividends would result in higher interest rates on municipal bonds. And there have been the usual budgetary anxieties about estimated revenue losses. In the end, however, something significant is going to happen.
Faced with senior backlash, a dwindling number of national legislators appear willing to stand up for the sheer principle of taxing dividends twice. On the other hand, state governors’ efforts to steer overtaxed investors toward municipal bonds have been a familiar but annoying distraction. At a recent gathering of congressional Republicans, I was asked, “Since there are always winners and losers from any tax change, who would lose from eliminating the double taxation of dividends?” That congressman echoed the common hunch that interest rates on municipal bonds would have to go up to compete with single‐taxed dividends. When Fed Chairman Alan Greenspan testified before the Senate budget committee, he too was asked what to do about this alleged effect on “munis”.
Just as bond yields contain an “inflation premium” to compensate for inflation, taxable bonds also contain a “tax premium” to compensate for high tax rates. That is why tax‐free bonds pay a lower rate of interest than taxable bonds of comparable risk. What happens when high tax rates are reduced, however, is not that the yield on tax‐exempt bonds goes up, but that the yield on taxable bonds goes down.
Issuers of tax‐free bonds have lobbied against every reduction of every tax rate since at least 1981. But look what happened when the top tax rate dropped from 50 percent in 1986 to 37.5 percent in 1987 and 28 percent in 1988. The yield on 30‐year Treasury bonds fell 3 percentage points in 1986, from 10.8 percent to 7.8 percent, while the yield on the S&P index of high‐grade municipal bonds fell by “only” 1.8 percentage points. What matters to states and cities is not the spread between their rates and Treasuries but the absolute level they have to pay. And shrinking the tax premium shrinks interest rates generally.
Since the tax boost of 1993, ironically, the spread between taxable and tax‐exempt bonds narrowed and nearly vanished, dropping to only three‐tenths of a percent from 1998 to 2001. The greater risk of default on state and local securities has swamped any tax advantage.
Bringing the top tax back down to 35 percent will reduce the tax premium in taxable bonds, as in 1986, not raise the yield on tax‐exempts. As for dividends, the public made half of them tax‐exempt already by keeping them inside pension funds and foundations. Making the other half tax‐exempt will increase the flow of dividends in taxable accounts, but that will not affect municipal bonds yield a bit.
The only other politically potent objection to the president’s plan is the estimated revenue involved. Those estimates are static, and presidential adviser Glenn Hubbard figures improved investment could pare the actual cost by 40 percent. But that still leaves a 10‐year tab above $200 billion. Budgetary pressures may be pushing even taxpayer‐friendly congressmen to consider scaling back the dividend plan to conserve some tax‐cutting ammunition for other chores, like killing the alternative minimum tax.
There are four alternative dividend tax plans floating about, whose effectiveness cannot be judged by the amount of revenue they supposedly lose. Yet that may be a good place to start.
In a recent column, I mistakenly implied a plan proposed by Newsweek columnist Allan Sloan had the blessing of the Brookings Institution, simply because he used their estimates. In fact, Brookings has taken no stand in favor of any such proposal. And I, too, will use some figures from the Tax Policy Center, a co‐venture between the Urban Institute and Brookings Institution.
The Center estimates that taxing dividends at the same rates that we tax long‐term capital gains (10 percent to 20 percent) would cost the IRS $78 billion over 10 years. Cutting dividend tax rates by half (5 percent to 17.5 percent) costs twice as much — $168 billion. Both of those estimates include the president’s clever basis adjustment to eliminate capital‐gains taxes to the extent they reflect retained earnings. Although the 50 percent deduction is a larger tax cut than capping the tax at 20 percent, I nonetheless favor the latter plan because it taxes dividends the same way we tax capital gains and I believe we should tax income from investments at a single, flat rate. I have explained in previous columns why I believe either of these two plans would be static “revenue neutral,” with little or no revenue loss over time.
Another worthy alternative would be to allow corporations to deduct dividend payments. Unfortunately, congressional stinginess is an even bigger problem here than with the president’s plan. Steve Entin of the Institute for Research on the Economics of Taxation notes that corporations paid some $376 billion in dividends in 2000, but individuals reported only $145 billion of dividend income, some of which was interest. Full deduction at the corporate level clearly entails much bigger revenue losses than an equivalent deduction for individuals because many dividends end up in tax‐exempt pensions and organizations.
One genuinely meaningless gesture is the idea of excluding, say, the first $2,000 of yearly dividends from taxation, while taxing the next dollar at ordinary income tax rates. That scheme would lose about $60 billion over a decade without the slightest beneficial impact on marginal decisions.
As soon as dividends reached the limit, investors would prefer capital gains to larger dividend payments and might even sell dividend‐paying shares to avoid the nasty notch in their marginal tax. Excluding the first few bucks of dividends is a plan that maximizes the revenue loss while minimizing the economic benefit. It is no better than doing nothing, maybe worse.
Something much better is going to pass. Meanwhile, standing in the way will prove politically hazardous to legislators from either House and either party.
I have seen some journalistic speculations that Congress is going to do little or nothing this year about double taxation of dividends. If anyone has the courage to offer a wager on that, take the bet.