Before 2003, when a person received dividends from his stock holdings, this income was taxed at ordinary income tax rates. That is, a dollar of dividends generated the same individual income tax liability as did a dollar of wages.
But many economists have long argued against taxing dividends this way. Dividends are a stockholder’s payment from corporate profits, and these profits have already been subject to the corporate income tax. Any tax on dividends represents a second tax on essentially the same income.
One can question whether this double taxation of income from corporate capital is fair. But fairness aside, there is also the problem of incentives. Taxing dividends twice substantially raises the overall tax burden on this form of income and distorts various decisions. Whenever taxes, rather than true costs and benefits, drive the allocation of resources, the economy shrinks below its potential.
Here are five ways a heavy tax on dividends messes things up:
CONSUMPTION VS. SAVING When the tax system depresses the return on a major asset class like corporate equities, households have less incentive to save for the future. Reduced saving means less funds for capital accumulation, which in turn impedes economic growth.
HOUSING VS. BUSINESS CAPITAL Wealth invested in your own home has several tax advantages. These include the mortgage interest deduction and the absence of any tax on imputed rent (the value that homeowners earn implicitly by getting a place to live). By taxing business capital highly, the tax laws induce people to invest too much in housing and too little in businesses.
NONCORPORATE VS. CORPORATE Because noncorporate businesses like partnerships are taxed only once, they have an advantage over twice-taxed corporations. As a result, too much of the economy’s capital stock ends up in the noncorporate sector.
DEBT VS. EQUITY FINANCE Because interest payments on corporate debt are deductible for corporate income tax calculations, this capital income is taxed only once. This asymmetric treatment of debt and equity finance induces companies to issue more debt than they otherwise would, increasing leverage and the economy’s financial fragility.
RETAINED EARNINGS VS. DIVIDENDS Companies can avoid the dividend tax by retaining earnings rather than paying dividends. Excessive retained earnings, however, impede the movement of capital from older cash-generating companies to newer ones with better prospects.
Tuesday, September 09, 2008
Dividend Taxes Cause Over-Investment in Housing
Harvard economist Greg Mankiw says taxes on dividends "induce people to invest too much in housing and too little in businesses":