January 17, 2003
From the desk of Jane Galt:What Are the Rich Getting Away With This Time?
What, my correspondants ask, is to keep evil rich people from taking advantage of the new dividend taxation scheme by forming corporations and taking all their income as untaxed dividends? Or setting up similar deals for managers? The subtext seems to be, "Bet you thought you could slip one by us regular folks, hmmm?" Well, you know me, Jeremiad Jane, Shill for the Military-Industrial Complex. I'm sure I'm going to disappoint the readers who thought they'd caught me pulling a fast one, but the answer, my dears, is "the tax code".
Before I explain myself further, I'd like to try to convince you of a proposition that is basically non-controversial in economics: that it doesn't matter whether you tax the employer or the employee; the employee still pays the tax.
Think of it this way: your boss has some amount of money he is willing to pay for your services. Any more than that, and he'll find someone else, or another way to accomplish the tasks he was willing to pay you for. Say that amount is $50K per year.
Now say that the government slaps a 10% tax on wages, payable by the employer. Say further that you are a crack negotiator who has extracted the maximum $50,000 he is willing to pay in salary bargaining. Does your boss go down to the money tree on the back lawn and pick another $5,000 to pay you with? Of course not. He fires you and hires someone cheaper. Or gets a machine to do the job. I had a nice email from a guy at a company making restaurant equipment a while back, saying that he could always tell when a state had raised its payroll taxes or its minimum wage -- there was a huge spike in purchases of labor-saving equipment from that state.
Salary negotiations basically go like this: your company has a maximum they will pay. You have a minimum you will accept. You settle on an amount somewhere in this range; exactly where depends on how good a negotiator you are.
Now add taxes into the equation. Say your boss is willing to pay a total of $50,000, and you're willing to accept a minimum of $40,000. Now, let's add a payroll tax of 10% into the picture. What does that mean? It means that the maximum you will actually get paid is $45,454. If you demand more than that, they will not hire you, because it will push their expense over $50,000.
Now let's imagine it's not a payroll tax, but an income tax of 10%. You'll get slightly less at the maximum: $45,000, rather than $45,454. But the difference is not large compared to the $4500 you lose to the tax. The effect of both taxes is to cap your after-tax salary around $4500 -- even though one tax is nominally imposed on the employer.
And that, my friend, is why companies can't just use the new dividend tax to make salaries to top managers tax free. When you look at a salary, you can't just look at the benefit to the employee; you also have to look at the cost to the corporation. And in this case, there's a big cost to paying salary in dividends instead of wages: salaries are tax deductible, but dividends are not.
Let's imagine again that the corporation is willing to pay a manager $50,000 net of taxes, and the manager is willing to take $40,000 net of taxes. Now, let's examine what happens under the two alternatives. We will assume, for the purposes of the excercise, that the manager is a real sharpie and squeezes every last dime out of his company.
Regular salary:
The company is willing to pay up to $76,923. Why? By paying that amount, the company saves $76,923 X 35% on its taxes: $26,923. That leaves them an after-tax cost of $50,000. Assuming an income tax burden of 20% (yes, this is NOT like real life), that leaves our manager a comfortable after-tax income of $61,538.
Salary paid as dividends:
Now, assume the company wants to pay the manager a nice tax free salary using some dodge to pay his salary as dividends. How much are they willing to pay? $50,000. Why? Because dividends aren't deductible. He gets it tax-free -- but he's worse off than under the regular salary scheme. Note that a dodge to get the employee his salary tax-free only really works when the employee's average income tax rate is higher than the corporate income tax. But that happens only at very, very high levels of taxation, and also, with the new phase-outs there won't be anyone in the country paying a higher rate than the corporate tax. So no one is going to pull that particular dodge.
The same goes double for rich people. Why would you dump your assets into a corporation for the pleasure of paying a 35% bite off every dollar if your marginal rate was lower than that?
There are corporate forms in which the company does not pay the corporate income tax, such as the partnership, the REIT, and the S-Corporation. However, those entities also do not benefit from deductible dividends. So while I'm sure that people would set up an entity to dodge their tax burdern if they could (and in fact, they do so all the time -- what do you think tax lawyers do all day?), this law is not going to help them accomplish their goal. It is going to shift capital distributions from stock repurchases, which were popular in an era of tax-advantaged capital gains, but it is not going to make it so they get to mint money without paying off Uncle Sam.
Next question?
Posted by Jane Galt at January 17, 2003 4:28 PM | TrackBack | Technorati inbound linksAnother reason to do away with corporate taxes, as well as progressive taxation. Eliminate the tax-wedge between physicians and patients, for example, and consumer health care prices will drop appreciably.
The other thing that makes this a non-loophole is that tax-free dividends have to come out of earned, taxed income under the administration's plan. Each company will keep an account that will correspond to the amount of earned income they can distribute tax-free to shareholders.
So you can't create a tax loss in the entity (hence avoiding taxes) but then pay out a tax-free dividend to shareholders.
Of course, this accounting is one of the annoying complications of the proposal, but it certainly forecloses many creative tax accounting possibilities.
Okay, here's another question- Why wouldn't it be a better fix of the Double Taxation of Dividends problem to simply allow corporations to deduct dividend payments from their Net Income before taxes(as they do with interest) that seems to be where the problem is. I'm all for lowering, or getting rid of, any taxes, but this seems like a backwards way of solving the problem.
Moe, my guess would be politics. Which can you sell easier, John Q. Public getting a tax break on dividends or the Evil, Bloodthirsty, Kill Grandma and Little Babies Corporation. I can just hear those opposed to any tax cuts trotting out the lame why should Enron-type companies get a break on taxes, instead of the working class.
>>> What ... is to keep evil rich people from taking advantage of the new dividend taxation scheme by forming corporations and taking all their income as untaxed dividends?
Two very simple answers:
(1) The distributed income must be taxed at the corprorate level, and for anyone who's "evil rich" the corporate tax rate is higher than the personal tax rate -- in fact, about 10 points (or one-third) higher at 39% marginal for much of the way. That's a "stopper" right there.
(2) People can already get single-taxed income at lower personal rates -- *much* lower with a little planning -- by setting up an S corporation, partnership or limited liability company, instead of a regular (C) corporation that pays taxable dividends.
In fact, almost nobody sets up a new C corporation any more. The alternative entities now earn about 50% of all business income in the US. Almost all C corporations are old businesses that were set up before the alternatives became available, or public companies. (Only C corps can go public).
>> Why wouldn't it be a better fix of the Double Taxation of Dividends problem to simply allow corporations to deduct dividend payments from their Net Income before taxes(as they do with interest) that seems to be where the problem is.
Well, economically that *might* be better on net, but...
1) It would be *much* more expensive budget-wise, and this proposal is already being bashed as a budget buster.
2) Some corporate income would become "no taxed". The corp would get a deduction for dividends at its level even if they were paid into a pension plan or retirement account and not taxed there. The Bush proposal makes sure dividend distributions are taxed once.
3) A lot of the benefit of the corp-level dividend deduction would go to foreingers who own stocks of US corps -- and no politician wants to pay a cost to benefit people who can't vote in the US.
4) As a previous comment noted, it would look more like a break for rich corporations (bad) than for people. The Repubs want you to see that deduction on your own personal tax return every year and remember it thankfully on election day.
So it is a combination of economics and politics. But it is good that there is some real economics in there -- often it is 100% politics where the tax code is concerned.
This is why I always laugh when contractors "go direct" and complain about their pay cut, even though they now get subsidized medical insurance and the company "pays" part of their taxes. They may have had cheaper medical insurance before (or not), but they never seem to understand that the hourly rate for contract vs. direct employess is not directly comparable.
Bolie IV
What I really hope is that more and more people are starting to understand things like this. You don't need a Ph.D. in economics to understand it--although having one makes you good at explaining it, I suppose.
I remember that P.J. O'Rourke once asked an economist friend of his what, if anything, in economics could not be explained in plain English and common sense. His friend had to think about it for a while.
The IRS is already very unfriendly towards
small business owners that take huge salaries
in order to avoid dividends.
The nice thing about the plan is it gives people
a tool to decide whether they want to be taxed
at a corporate rate or their personal rate. Whether you want to do that or not kinda depends what your tax planner has to say.
Anyway, I think this your explanation is a
very well reasoned argument. I just wanted to comment about the "evil rich people" bit. A
corporation costs about $100 to set up in
Georgia, and you don't even need a lawyer. The
potential benefits of the law go to people who are willing to learn how to take advantage of it.
Saying "evil rich people" is like saying
"dumb poor people". If average people learn
to play by the rules, they'll have a much better
time getting rich.
That's *my* plan anyway... YMMV :)
-Michal
And this discussion is NOT about taxes anyway. As Brad DeLong recently let the cat out of the bag with this statement:
http://www.j-bradford-delong.net/movable_type/archives/001391.html
more-or-less force federal government spending up from its current twenty percent or so of GDP to somewhere between twenty-five and thirty percent
over the next generation. [Steve] Cecchetti's belief that taxes should be restricted to 19 percent of GDP and debt to 50 percent is a decision to award victory to one side of American politics in a debate that has yet to
be started. >>
It's about increasing the size of the federal govt. by up to 50%. Just as Milton Friedman recognized in his January 15th WSJ Op-ed piece.
Anyone other than Jason McCullough think that won't have a negative impact on economic growth?
The only problem I see with your analysis, Jane, is hat it assumes corporations are. in fact, the profit-maximizing entities presumed by economic theory. If the past few years have taught us anything, however, it's that corporations, like any other entity, are run for the benefit of the people who run them. Thus, I am somewhat more skeptical about the behavior of corporate officers in the face of tax free earnings...
jimbo, you've just made Megan's case for her. Making the dividends tax free (or making them deductible to the corporation paying them)gets rid of an excuse for these officers not to pay dividends but to engage in accounting gimmicks to boost stock prices.
People like Paul Krugman, who have been whining about the lack of transparency in corporate accounting should favor Bush's plan (or something similar). That they do not, shows that Milton Friedman's analysis is probably correct; they're against anything that threatens to hinder the large increases in govt. spending they wish for.
Companies can issue enough stock options to complete eliminate virtually any tax burden, though, right? I've actually never seen an explanation of that.
Anyone other than Jason McCullough think that won't have a negative impact on economic growth?
It'll cause a one-time cut in output of unknown size, but I see no reason it'd slow down (entirely productivity determined) growth.
Stock options don't eliminate the tax burden, Jason; they're tax favored because they allow companies and individuals to defer taxes, but they do not allow people to evade them entirely. Stock options would have been tax disadvantaged if congress hadn't passed a law limiting the deductibility of executive salaries.
I've never worked for a company where I didn't have to pay full taxes on stock options. In my experience, you pay taxes on the difference between the purchase price of the option and current value, because that much of the option is value passed from the corporation to the individual. If the stock has gained value at the time the option is exercised, then you also get hit with capital gains tax.
I'm sure Mindles or Jane could edify you regarding tax code, Jason. But it's my strong impression that there ain't no such thing as a free lunch, when it comes to income. The IRS gets its pound of flesh sooner or later.
Oops. Made an error in the above. You pay capital gains at the sale of the stocks you have purchased under an option. So you have to keep record of the purchase price, the option price, and how much tax (if any) you paid when you received the option. And, of course, the price at which you sold the stock.
Jason, you are amazing!
A permanent increase in the size of the federal government to 30% of GDP, will result in a "one time cut in output"?
Jimbo --
I don't need to assume anything of the kind. Whether or not managers attempt to maximize shareholder value or not, the fact is that there is some maximum amount that the company will pay him. You may think that that amount is outrageous, and that the executive is not worth his salary, and I'd probably agree with you, but that is neither here nor there. The fact is there is a limit, if only the amount of cash or stock in the kitty.
Given that there is a limit, executives will pay themselves the form of compensation that is overall tax advantaged, because that maximizes both company and individual value. As I showed above, dividends are a tax disadvantaged form of compensation, particularly since they are not deductible in years when the company has not declared a taxable profit. That would make dividends far too volatile a form of compensation to take as your major income.
Ah, so options just transfer tax liability from the corporation to employees? Makes sense, especially with the lower tax rates on capital gains.
A permanent increase in the size of the federal government to 30% of GDP, will result in a "one time cut in output"?
Yes. I'm assuming the alternative result you're advocating is "a cut in the rate of economic growth"; I'd love to see the model/explanation if you have one.
Comments are Closed.