A key feature of the Bush economic stimulus plan is the elimination of double taxation of dividends. The IRS gets a double dip because dividends are actually income to two different "people." The word "people" is in quotes here because it's hard to think of corporations as persons, but in the legal sense that's exactly what they are. A company's articles of incorporation can be thought of as a birth certificate for what is known as a "fictitious legal entity." This entity has the financial rights and responsibilities of a person; it can own assets like machinery and factories; it can legally transact purchases and sales; it is responsible for its products and can be sued if they cause harm to other persons. And, like you and me, a corporate entity can earn an income. When it does, it pays taxes. That's once.
A corporation is managed by a CEO and a board of directors, but it is owned by stockholders. Buying a share of stock means giving your money (the price of the share) to the corporation, which in turn buys the capital necessary for operation. What do you get in this transaction? You are actually purchasing two things: 1) the right to vote for the directors, and 2) a share of corporate profits. When corporations distribute profits to shareholders, they're called dividends. For shareholders, those dividends are income. Personal income is taxed. That's twice.
Here's an example from the Institute for Research on the Economics of Taxes (IRET). Suppose a corporation earns a total of $1/share and you own a share. How much of that dollar will you actually get to spend if the corporation distributes the earnings as dividends?
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* The highest individual tax bracket. Adjust the multiplier
for lower tax rates.
** This rate is higher if state and local taxes are added.
"Dividend Tax Relief and Other Measures Aimed at Boosting The Stock Market - Methods and Consequences" by Stephen Entin, Institute for Research on the Economics of Taxation
It's hard to argue with the numbers. Taxation takes a big bite from investors, reducing incentives to invest. Investment is essential to the continuing health and future growth of our economy, so it's not surprising that since the 1970s, Presidents from both parties have considered eliminating double taxation. What is surprising is that the change has only been considered and not carried out. If there's broad agreement that double taxation can be a drag on the economy, why is the Bush administration's proposal causing such an uproar? The issue, it turns out, isn't what to do, it's how to go about it.
As you look at the chart above, it should occur to you that double taxation could be eliminated either at the corporate level or, as the President has proposed, at the individual level. Should the corporation get the tax relief, or should the individual shareholder? The difference in who benefits from the tax relief is the cause of the dividend debate.
Washington Post columnist David Broder contends that by eliminating the tax at the individual level, Bush's proposal panders to the wealthy. "According to an analysis by the Urban Institute and the Brookings Institution, 64 percent of the $364 billion in benefits from dividend tax elimination would go to the top 5% of taxpayers, the same people who are the main beneficiaries of the Bush tax cut in 2001."
Besides making the fat cats fatter, he argues, the plan passes right by people who could really benefit. "Moreover, [the plan} . . . would not affect the mass of dividends that go into the 401(k) plans on which most working Americans depend for additional retirement income. Those dividends are not immediately taxed now, and the taxes due when the money is withdrawn would remain unchanged under the Bush proposal. "
Make no mistake, Broder supports the elimination of double
taxation. He just thinks the President is targeting the wrong
part of the tax code. Instead of putting more money in wealthy
pockets, ". . . business groups and almost all economists
agree that the right way to remedy the situation is to make
dividend payments deductible for the corporations."
("Right problem, wrong solution," by David Broder,
The Denver Post, January 12, 2003)
Writing in The New Republic, Ryan Lizza takes exception to the suggestion that eliminating the personal income tax on dividends is a boondoggle for the rich. "Democrats are already calling the tax cut a payoff to Bush's [wealthy]. . . allies. But that analysis doesn't quite hold up. . . . If Bush really wanted to reward the business community, he would have proposed eliminating this tax at the corporate end. But fearing being tarred as too close to corporations, he rejected this approach. . . ."
The key to understanding the Bush proposal, Lizza argues, lies in predicting what stockholders will do with the "extra" money. Recent economic analysis offers an unexpected answer to that question. "In the past, liberals and conservatives both discounted the stock market's role in stimulating the economy. But, during the Clinton boom, this view began to change. . . . Economists call it the 'wealth effect' . . . . Simply put, the wealth effect is the extra dollar amount a person spends from an increase in wealth. The theory is that the 1990s stock boom [and expanding economy] dramatically increased the net wealth of many Americans. The stock market soared, investors' portfolios fattened, and . . . investors' net wealth shot up, leading them to consume more. . . . That investor-class consumption drove the '90s economy." ("White House Watch - Wealthy Choice," by Ryan Lizza)
Federal Reserve Board economists Michael Palumbo and Dean Maki have provided influential research evidence supporting the existence of the wealth effect, upsetting generally accepted thinking about how to stimulate a sluggish economy. Their work undermines ". . . the traditional economic view that to stimulate the economy, cash must be pumped into the hands of lower-income Americans . . . because they are more likely than the wealthy to spend that extra disposable income. For adherents of the wealth effect, the way to boost consumption is to make relatively wealthy investors feel richer by juicing the stock market. One of the main critiques of the wealth effect was that it was impossible that the small slice of shareholding households was responsible for so much extra spending. But Palumbo's research says that is exactly what happened. '[A]ll of the consumption boom [of the '90s] really can be attributed to the richest groups of households,' his paper argues." ("White House Watch - Wealthy Choice," by Ryan Lizza)
Prof. Russell Roberts of Washington University, speaking on NPR's Morning Edition this month, also supports dividend tax relief to the individual. Arguing that tax reduction will increase incentives to invest, Roberts predicts that we won't have to look any farther than the mirror to find the beneficiaries of tax-free dividends.
"The President's plan increases how much investors get to keep, after-tax, from investing in successful companies. That makes it easier for corporations to raise money. . . . That gives corporations more machinery and capital to work with, boosting productivity and wages.
Getting rid of the taxation of dividends will make some people richer. But it will also make the rest of us richer, too. Not just those of us who happen to invest in dividend paying stocks. The real gain will be an increase in investment that will raise our wages and our standard of living." ("Cut Taxes, Help the Rich. (And the rest of us, too)," by Russell Roberts)
Discussion Questions
-
The U.S. income tax code is based partially on the principle of "ability to pay," the argument that individuals with bigger incomes should bear a bigger proportion of the burden of taxation. What are the advantages of basing taxation on ability to pay? What are the dangers of basing taxation on ability to pay?
- Taxation can also be based on the principle of "benefits
received," meaning that those who most benefit from
government and government programs should bear the burden
of taxation. (A simple example of a benefits-received tax
would be a toll. If the city builds a shortcut to the airport
and charges a toll, only those who choose to use the road
- and receive the benefits of doing so - pay the tax.) According
to IRS data, the top 1% of American taxpayers have an average
income of $1 million, and paid 25.1% of federal income taxes
in 2001. Is it possible to justify this burden in terms
of "benefits received"?
- If proponents of the wealth effect are right, how does
giving a tax break to wealthy stockholders benefit the poor?
What if proponents of the wealth effect are wrong?
- Denver Post business editor Al Lewis cites statistics
from the Tax Foundation and the Institute on Taxation and
Economic Policy indicating that the top 25% of taxpayers
(incomes of $55,000 +) pays 84% of federal taxes. The distribution
of the tax burden on this 25% can be further broken down
as follow:
- the top 1% of taxpayers (avg. income $1 million) pays 25.1% of federal taxes
- next 4% of taxpayers (avg. income $204,000) pays 18.1%
- the next 20% of taxpayers pays 40.8%
The New Republic reports that- 2/3 of voters own stocks
- over the past 3 years, the stock market has lost $7 trillion in value
How do these statistics affect your thinking about the fairness of the President's proposal?
How do these statistics affect your thinking about the economic impact of the President's proposal?
Further Research
- One-screen
summary of the President's economic stimulus proposal
- . One impact of the double taxation of dividends is to provide incentives for corporations to seek financing through debt (the issuing of bonds) rather than through the equity markets (issuing stock). Debate over whether to offer tax relief at the corporate level (as Broder argues) or at the individual level (as the President has proposed) also looks at the likely effects on debt vs. equity financing by corporations. For a very readable analysis of the various options and their predicted effects, see the IRET Congressional Advisory, "Dividend Tax Relief and Other Measures Aimed at Boosting the Stock Market - Methods and Consequences." (6-page PDF file from the Institute for Research on the Economics of Taxation)
Teacher Guide
Sources Used
Sources used:
- " Broder, David. "Right problem, wrong solution," The Denver Post, January 12, 2003.
- " Entin, Stephen. "Dividend Tax Relief and Other Measures Aimed At Boosting The Stock Market - Methods and Consequences," IRET Congressional Advisory, August 30, 2002.
- " Lewis, Al. "Let's try trickle-up economics," The Denver Post, January 12, 2003
- " Lizza, Ryan. "White House Watch - Wealthy Choice," The New Republic, January 9, 2003
- " Roberts, Russell. "Cut Taxes, Help the Rich. (And the rest of us, too)," NPR Morning Edition, January 16, 2003.
Discussion Questions
-
The U.S. income tax code is based partially on the principle of "ability to pay," the argument that individuals with bigger incomes should bear a bigger proportion of the burden of taxation. What are the advantages of basing taxation on ability to pay? What are the dangers of basing taxation on ability to pay?
Advantages of ability to pay taxation include the ease of raising large amounts of money for government's expenses without causing hardship for people struggling at the lowest income levels. Another advantage is the widespread perception that such progressive taxation is essentially fair. A disadvantage of basing taxation on ability to pay is the danger that high tax rates on the wealthiest citizens will act as a disincentive for them to engage in the productive activities that will generate more goods, services, and employment. (For example, what happens to the incentive for a millionaire to earn the $1,000,001st dollar as that dollar is taxed at 50%, 75%, 90%?)
- Taxation can also be based on the principle of "benefits
received," meaning that those who most benefit from
government and government programs should bear the burden
of taxation. (A simple example of a benefits-received tax
would be a toll. If the city builds a shortcut to the airport
and charges a toll, only those who choose to use the road
- and receive the benefits of doing so - pay the tax.) According
to IRS data, the top 1% of American taxpayers have an average
income of $1 million, and paid 25.1% of federal income taxes
in 2001. Is it possible to justify this burden in terms
of "benefits received"?
A plausible argument holds that it is the wealthy who benefit most from being Americans, and that they should contribute most to the government that fosters and protects their ability to become wealthy.
- If proponents of the wealth effect are right, how does
giving a tax break to wealthy stockholders benefit the poor?
What if proponents of the wealth effect are wrong?
If the wealth effect exists, then tax breaks, stock market gains, anything that makes wealthy people feel more wealthy, increases their propensity to spend. This translates into economic growth, rising wages because of increased demand for labor, and higher standards of living throughout the economy. If the wealth effect doesn't exist, then giving extra money to the wealthy has no stimulating effect on the economy; in effect, the rich would get richer and nothing would change for the poor. In that case, Bush's hopes that the dividend tax break will act as an economic stimulus won't be fulfilled.
- Denver Post business editor Al Lewis cites statistics
from the Tax Foundation and the Institute on Taxation and
Economic Policy indicating that the top 25% of taxpayers
(incomes of $55,000 +) pays 84% of federal taxes. The distribution
of the tax burden on this 25% can be further broken down
as follow:
- the top 1% of taxpayers (avg. income $1 million) pays 25.1% of federal taxes
- next 4% of taxpayers (avg. income $204,000) pays 18.1%
- the next 20% of taxpayers pays 40.8%
The New Republic reports that- 2/3 of voters own stocks
- over the past 3 years, the stock market has lost $7 trillion in value
How do these statistics affect your thinking about the fairness of the President's proposal?
How do these statistics affect your thinking about the economic impact of the President's proposal?Accept a variety of answers. Note that "2/3 of voters" can't all be in the highest income brackets. Also note the average income and income range in the various categories. For example, if the average income of the top 1% is $1 million, and we know this includes people like Bill Gates and wealthy baseball players, who else must it include in order to bring the average down to $1 million? Expect some debate among students about how much income qualifies a person as "wealthy." Students will also differ on how much burden they think the wealthy should bear and how much the tax code should be tipped toward the "ability to pay" philosophy.