Dividend Taxation: Nearly All Major Nations Relieve Double Taxation

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Mr. Chairman and members of the Committee, thank yo u forinviting me to testify today regarding the President's new taxproposals.

President Bush has proposed a generally pro-growth package thatwould save taxpayers $670 billion over 10 years. The tax packagewill have positive effects on short-term econo mic growth. Moreimportantly, most features of the plan are winners for long-termeconomic growth. Long-term growth will be spurred by the proposalsto accelerate the individual marginal tax rate reductions, expandsmall business capital expensing, and the proposed reduction intaxation of capital income in the form of the dividend and capitalgains tax cuts.

The highest marginal rates in the federal tax system cause thelargest distortions or socalled deadweight losses to the economy.The Bush plan focuses on reducing high tax rates. The currentdouble taxation of corporate earnings paid out as dividends resultsin a marginal federal tax rate as high as 60 percent. The Bushproposal would exempt dividends from tax at the individual level,which would drop the top dividend rate to 35 percent and make thetax treatment of dividends roughly similar to the treatment ofinterest.

Problems Caused by High Dividend Taxes
As the administration and others have observed, high dividend taxrates reduce economic growth by creating numerous distortions.First, high dividend taxes add to the income tax code's generalbias against savings and investment. Second, high dividend taxescause corporations to rely too much on debt rather than equityfinancing. Highly indebted firms are more vulnerable to bankruptcyin economic downturns. Third, high dividend taxes reduce theincentive to pay out dividends in favor of retained earnings. Thatmay cause corporate executives to invest in wasteful orunprofitable projects. Fourth, high dividend tax rates create abias against business organized in the corporate form. And fifth,high tax rates on dividends and other types of capital incomegreatly increase the wasteful efforts of financial engineers todesign ways of avoiding and evading taxes.1

U.S. Has the Second Highest Dividend Tax Rate in theOECD
The benefits of reduced dividend taxation have been recognized bynearly every other industrial country. Indeed, the latest data fromthe Organization for Economic Cooperation and Development (OECD)shows that the U.S. has the second highest top tax rate ondividends, when considering both the corporate and individualtaxes. (Figure 1 in my written testimony) The OECD data includesstate and local taxes, but even just the U.S. top federal rate of60 percent would give us the fifth highest tax among the 30countries.2

Methods of Relieving Double Taxation
The U.S. has the second highest top rate of dividend taxation fortwo reasons. First, the U.S. has one of the highest statutorycorporate income tax rates in the industrial world. Again, lookingat the 30 OECD countries, the U.S. has the fourth highest corporatetax rate, according to KPMG data. Second, 27 of 30 OECD countrieshave adopted one or more ways of reducing or eliminating divid enddouble taxation. 3 Only Ireland, Switzerland, and the United Statesdo not relieve dividend double taxation. But Ireland andSwitzerland have much lower corporate tax rates than we do.

Table 1 in my written testimony detailes the different methodsthat the 27 OECD countries use to partly of fully relieve doubletaxation.

Individual rate reduction. The most popular wayto relieve double taxation is to simply tax dividends at a flatrate, lower than the ordinary rate on wages. Countries that providea special low rate on dividends include Austria, Belgium, the CzechRepublic, Denmark, Italy, Korea, the Netherlands, Poland, andPortugal.

Some countries, such as Finland, Norway, and Sweden, have movedto so-called "dual income tax systems" that impose higher rates onwage income but lower flat rates on all forms of capital income.Those countries have lowered rates on capital income because ofincreasingly global tax competition, which is drawing billions ofdollars of investment capital to low-tax countries. Many countriesare realizing that high tax rates on capital income are becomingunsustainable in today's global economy.

Individual exclusion. Two countries, Germanyand Luxembourg, provide a 50 percent dividend exclusion toindividuals (e.g. if $1,000 in dividends is received, only $500 istaxed). Greece fully exempts domestic dividends from individualtaxation - basically the approach taken by the Bushadministration.

Individual credit. The traditional way toprovide double taxation relief was to provide individuals adividend tax credit to fully or partially offset the corporateincome tax paid on the earnings.4 This is sometimes called adividend imputation credit. Countries offering tax credits thatpartially offset corporate- level tax include Canada, France, andthe U.K. Countries providing credits that fully offset doubletaxation include Australia, Finland, Italy, Mexico, and NewZealand.

Norway provides a full dividend credit and has a flat individualtax rate of 28 percent on all capital income, with the result thatit has the lowest overall dividend tax rate in the OECD of just the28 percent.

The New Zealand system is also interesting. That countryprovides a full credit to eliminate dividend double taxation, andit also dropped its individual capital gains tax rate to zero toeliminate any bias against retained earnings that would haveotherwise resulted.

Nonetheless, there has been a movement away from the individualdividend credit approach toward simply offering lower dividend taxrates in recent years.

Corporate deduction. Dividends can be givenparallel treatment to interest by allowing corporations to deductdividends at the corporate level. The Czech Republic and Icelandallow a partial dividend deduction. A full corporate dividenddeduction may be the most simple and straightforward method ofcreating neutrality between interest and dividends, and thus shouldbe considered by Congress as an alternative to the Bushapproach.

Conclusion
To conclude, there is a global trend toward lower tax rates on allforms of capital income, including corporate income taxes andindividual taxes on dividends and capital gains.5 Policymakers inmany countries are recognizing that high capital income taxesdistort savings and investment decisions and reduce economicgrowth. As just one example, Canada is currently implementing aphased- in cut in its federal corporate income tax rate from 28percent to 21 percent.

In this country, Congress should begin reforming the tax code inline with global trends and reduce the high tax rates that arecurrently placed on

Thank you for holding these important hearings, and I lookforward to working with the Committee on these issues.


  1. William Gentry and R. Glenn Hubbard, "Fundamental Tax Reformand Corporate Financial Policy," National Bureau of EconomicResearch Working Paper 6433, February 1998.
  2. Data is from the OECD Tax Database emailed to author fromOECD-Paris, January 13, 2003. See also Isabelle Joumard, "TaxSystems in European Union Countries," Working Paper no. 301, OECD,June 29, 2001.
  3. Table 1 was complied by the author based on Ernst & Young,"The Global Executive 2002," October 2001; Paul van den Noord andChristopher Heady, "Surveillance of Tax Policies," Working Paperno. 303, OECD, July 17, 2001; and various other sources. Credits,exemptions, and lower rates are often only available for domesticinvestments.
  4. Often called the "dividend imputation" method.
  5. See Chris Edwards and Veronique de Rugy, "International TaxCompetition, A 21st Century Restraint on Government," CatoInstitute Policy Analysis no. 431, April 12, 2002.