Asymmetrical Information

"I'm sure there are political reasons behind the administration's chosen construction of relief from double taxation of dividends.."

Mindles,

I think this one is pretty straightforward. Bush's instincts are to lower taxes, and this is low hanging fruit (or at least he believes so).

Dividends ARE taxed twice and it will probably be pretty easy to convince people they shouldn't be. "Sale-ability" also probably explains why they are focusing on eliminating the tax for individuals, not corporations.

Mike is right - the political reasons are to lower taxes, and to make the tax code simpler. This does both.

Eliminating dividend taxes may have more of an impact on private firm owners than Wall St. investors, as it impacts how owners can get money out of their firms - it makes this much, much easier. (related question: if there are no dividend taxes, what is the point of an S-corporation?).

Expect tax consultants to organize and fight this one - they make hay out of helping your local carpenter and architect avoid dividend taxation, and won't want to see it go away...

The "double taxation" argument is ridiculous. When I pay a plumber to fix my sink, his salary is double taxed: first it comes out of my income taxes, and then it comes out of the plumber's. So what?

I would prefer to get rid of corporate taxes, and *only* tax dividends. It doesn't make sense to me that some ways of getting money (dividends, inheritence, capital gains) don't count as "income". Why not?

Not to mention the fact that if this is passed, corporate officers will assign their compensation commitees to make damn sure that all said compensation in the future is in the form of "dividends"...

Well, Darryl, then corporate earnings are taxed three times - the customer pays for a product out of taxed earnings, the company pays taxes, and then the dividend holder pays taxes.

A profit is (presumably) made when the plumber is paid. Profit is made when a corporation earns money. It is impossible to book a real profit from distributing earnings.

Secondly, the ultimate beneficiary of corporate earnings and dividends is the same entity.

The plumber pays his taxes, you pay yours. The corporation pays taxes on the shareholder's behalf, then the shareholder gets to pay more taxes when the dividend is distributed.

The point is that the same value-adding/income generating event is taxed twice to one beneficiary, resulting in a cumulatively punitive rate to that beneficiary of almost 60%.

Doesn't the pension angle suggest that excluding dividends from taxable income could actually end up HURTING the prices of dividend-paying stocks? If holding stock in a plan had the effect of converting nontaxable dividends to (deferred) ordinary income, plans would have an incentive to avoid or dump dividend-paying stocks. There'd be a lot of other effects as well, and the net effect might still be positive, but the effect on plans seems like a pretty major disadvantage to a dividend exclusion.

Mindles says: "Well, Darryl, then corporate earnings are taxed three times - the customer pays for a product out of taxed earnings, the company pays taxes, and then the dividend holder pays taxes."

That's my point---counting how many times a dollar is taxed is silly. You can certainly argue that corporations are taxed too much, but that has nothing to do with whether they are taxed once, twice, or fifteen times.

"A profit is (presumably) made when the plumber is paid. Profit is made when a corporation earns money. It is impossible to book a real profit from distributing earnings."

Who cares whether it is profit or not? If I'm getting $3000 a month from stock dividends, why is that less worthy of being taxed than if I get $3000 a month from working 160 hours?

"The point is that the same value-adding/income generating event is taxed twice to one beneficiary, resulting in a cumulatively punitive rate to that beneficiary of almost 60%."

Yes, the stockholder is not adding any value. So why should that mean he is taxed less? Mr. A works for the corporation: he puts in labor, and gets back a monthly check. Ms. B is a stockholder in the corporation: she puts in investment dollars, and gets back a monthly check. They each contribute something to the corporation, and they each get something back. Why should the first be taxed, and not the second?

I disagree with Mindles.

Dividend tax relief provides significant tax relief for the marginal investor. (And yes, the marginal investor is rich.)

Econ 101: Increase incentives for investment at the margins, you get more investment. Why, that's the definition of growth. Dividend tax relief will attract capital from both foreign and domestic sources. It effectively lowers the hurdle rate for investment.

Moreover, it puts all stockholders on a level playing field, whether an endowment fund or a construction worker. No more "crowding out" of dividend paying stocks by pension funds.

There are lots of reasons why the shareholder level is better than the corporate level.

However, there are also good reasons to allow a deduction at the corporate level, giving debt and equity equal treatment.

Bottom line: Both ideas are great, though admitedly imperfect.

-Steve

Stephen: To clarify, I agree with the "econ 101" point. I just don't think it happens rapidly.

Daryl: Because the "second" has already been taxed. Corporations are owned by shareholders. When the company pays tax, the value of their interest in the company decreases.

Milton: Hmm. The Mirror image argument has clear implications for municipal bonds. It changes the relative anticipated after-tax returns of investment choices for individuals. But does this change a pension plan's expected return for dividend-paying stocks vs. non-dividend paying stocks? I don't think so. Maybe I misunderstood you.

Preferred stock - now that's where we'll see some action.

>>Dividend tax relief will attract capital from both foreign and domestic sources.

Speaking as a non-US taxpayer, why should I give a monkey's what the USA does with its tax code?

I discuss this issue at length on my own weblog (pluggity plug)

I wasn't trying to quibble--your post was interesting and I'm trying to think through the implications. My thought was that if holding stock in a plan costs you the tax exclusion on dividends, plans would not want to hold dividend-paying stocks, just as they currently don't hold municipal bonds. If I'm reading right, you're saying that couldn't make stocks less valuable to plans than they are currently; prices might/should rise to a level at which such stocks were unattractive to plans, but that would only reduce the amount of any price increase. Am I understanding correctly? And even if I am, wouldn't this still tend to distort the taxation of capital even worse than it already is? (I think that's your original point.)

D^2:

I am under the impression that Uncle Sam takes his danegeld no matter where you live, if you want to buy on our exchanges.

All good points, but I think there are some other issues. By eliminating or reducing dividend taxes, more $ will be returned to investors rather than being held by the corporation as retained earnings. This means that reinvestment of these $ will be done thru decisions of the individual investor, not the corporation.

It seems that, at some point, corporations reach a point of diminishing returns in making internal investments...but ego factors tend to encourage them to (a)enter industries they know nothing about (b)make ill-advised mergers, and (c) just plain waste money. As someone put it, when a company retains earnings rather than paying them to you in dividends, they're in effect saying that *their* hundred-and-twenty-fourth-best idea is better than *your* second-best idea.

In fact, there have apparently been academic studies that show companies paying dividends tend to grow better than those not paying dividends (exactly the opposite of what would be expected if they were reinvesting retained earnings effectively.) Sorry I don't have a citation on this.

If the above logic is correct, then the effective use of capital throughout the economy should be improved by increasing the payout of dividends.
However, there's some danger of overdoing it..we don't want to see companies as obsessed with their dividend as they are now with quarterly earnings, to the point where they will "sell the tracks" on reasonable reinvestments.

>>I am under the impression that Uncle Sam takes his danegeld no matter where you live, if you want to buy on our exchanges.

Yes but this isn't going to change. I haven't seen the details of the plan, but as I understand it, when I receive a dividend out of income on which US corporation tax has been paid, I get a tax credit which allows me to reduce my liability for US income tax. Since Her Majesty's Commissioners of the Inland Revenue are unlikely to accept this in part payment of my tax liability, it's good as worthless to me. Or am I missing something?

The point is that the same value-adding/income generating event is taxed twice to one beneficiary, resulting in a cumulatively punitive rate to that beneficiary of almost 60%.

Except that corporations are legally distinct entities from the individuals that own them, and that's why they're taxed.

If most of corporation law is revoked to go along with the dividend cut, hey, I'm all for it.

"corporations are legally distinct entities from the individuals that own them, and that's why they're taxed"

Umm, no. Several types of legally-distinct entities are not taxed at the entity level (S corporations, partnerships, and LLCs, for starters). As it operates today, the corporate income tax is mostly a tax on being publicly traded. Most closely-held businesses are organized to avoid paying tax twice.

It's a shame the administration has chosen what looks like a fairly ham-handed way of addressing double taxation. By proposing a problematic approach, they risk not only failing this time around but also poisoning the well for other approaches that would make more sense.

It occurs to me that d squared may have stumbled onto the answer for the mystery of the proposal to eliminate the double taxation at the shareholder level. It would seem simpler to make dividends deductible, as interest payments are.

But if they were a tax deduction at the corporate level, then foreign owners of shares in American companies could avoid paying a tax to the IRS on their share of the earnings, by not filing an income tax return in the U.S. And I think it might be possible for Americans living abroad to escape also (but it's been many years since I looked at that law). American citizens living here would pay it on their personal returns.

However, I hope the reason the Bush Administration is for the elimination of this double taxation, is to remove an excuse that corporations currently have not to pay dividends. Which excuse allows them to instead play accounting games to run up the stock price.

Paul Krugman should be in favor of eliminating this excuse, in the cause of accounting transparency; it's hard to fake dividend payments.

Wow! Fascinating discussion.

A question: The 'White House briefing paper' on Bush's plan (I found it at wsj.com) uses the word 'seniors' when discussing the dividend tax break. That indicates to me the political purpose of the dividend tax break is to woo support from senior citizens. If so, does the plan make sense? One can presume that many seniors are relying - at least in part - on their dividend income to get by.

S.

> I understand it, when I receive a dividend out of income on which US corporation tax has been paid, I get a tax credit which allows me to reduce my liability for US income tax. Since Her Majesty's Commissioners of the Inland Revenue are unlikely to accept this in part payment of my tax liability, it's good as worthless to me. Or am I missing something?

When an American receives income from a foreign source, said American pays taxes on said income. However, said American does get credit as far as US taxes are concerned equal to the amount said American paid to the relevant foreign taxing authority on said income. As a result, if the foreign tax rate is lower than the US tax rate, changes in said foreign rate have no effect on the after-tax return of said American.

If the UK works the same way, not-taxing dividends at the individual level has no effect on foreigners from high-tax countries that provide similar credits. However, it does make a difference for other foreigners who receive US dividends.

Umm, no. Several types of legally-distinct entities are not taxed at the entity level (S corporations, partnerships, and LLCs, for starters). As it operates today, the corporate income tax is mostly a tax on being publicly traded. Most closely-held businesses are organized to avoid paying tax twice.

Don't the non-taxed entities have fewer rights and more liabilities?

No. They have different structures, but the liability implications of an S-Corp are no different; only the number of shareholders. Partnerships also are generally held as LLPs these days, mitigating liability.

Patrick:

>>It would seem simpler to make dividends deductible, as interest payments are.

Seem, but wouldn't be, unfortunately. Have a look for "advance corporation tax" on the Web for details of how horrendously complicated this system got in the UK before being abolished. The US appears to be going for a French-style system which is much simpler.

Andy: You're right, but you're thinking about double taxation of income tax. There's no means for Americans to recover the corporation tax paid on dividends from overseas companies; the credit for income tax paid overseas avoids triple taxation, but still leaves them double-taxed (I think)

This baffles me:

>>It would seem simpler to make dividends deductible, as interest payments are.

Seem, but wouldn't be, unfortunately. Have a look for "advance corporation tax" on the Web for details of how horrendously complicated this system got in the UK before being abolished.
---------------------------->.

U.S. corporations merely deduct their interest payments to bondholders now. Why would it be so complicated to add a line for dividends paid to shareholders?

Basically because it would mean that the 50% of dividends on which no income tax is currently paid would escape tax altogether.

dsquared: I think you've made a mistake in your last post. IRAs and 401ks are tax-deferred, not tax-exempt. Dividends paid into tax-deferred accounts would be taxed upon distribution. (Your comment is valid when applied to Roth IRAs, which are only open to income brackets

JT: Yes and no. 401(k) distributions are taxed as ordinary income, not capital gains (or should it come in, at the new dividend rate). So while it is true that these funds are tax deferred, not exempt, it is also true that the dividend taxes won't apply to them.

Mindles, I don't agree with the idea that stockholders and the corporation are the same entity. That's the whole point of incorporation, is to separate the stockholders from the corporation as entities. If you want to now say that they are one and the same, why not just eliminate the fiction of a corporation (and along with it the "limited liability" of stockholders)?

Anyway, as I said, I couldn't care less whether the same money is taxed once, twice, or fifteen times. If you want to make an argument for changing the tax laws, it should be in terms of what affect they will have on economic activity. Perhaps corporate income tax should be *eliminated*, and dividends and capital gains should be treated as ordinary income. It seems to me that not taxing dividends gives a new way for CEOs to avoid taxes---couldn't things be arranged so that the bulk of their compensation come from dividends, rather than salary?

>>It seems to me that not taxing dividends gives a new way for CEOs to avoid taxes---couldn't things be arranged so that the bulk of their compensation come from dividends, rather than salary?

Yes and there will presumably have to be some legislation to plug this otherwise fantastic loophole for anyone whose marginal rate of income tax is higher than the rate of corporation tax.

D^2:

In the United States, that will soon be no one. No loophole there.

Were the Democrats not innumerate they would counter with a proposal to eliminate corporate taxes altogether. All corporate profits would be paid to shareholders either as dividends or presumptive dividends and taxed at marginal tax rates. The result would minimize tax avoidance, management would have to attract reinvestment presumably with beneficial results for corporate governance, and IRAs would continue to provide their tax benefits.

John,

That's a very good point.

I've always felt the dems are going about taxes the wrong way, even allowing for their wish to have enough to pay for the social programs they like.

Someone's been reading the Jane Galt tax plan to eliminate the corporate income tax.

Nope, sorry Jane he has been going on about this for years now.

I was teasing. I'm hardly the first person to advocate these reforms.

I'm still baffled by d squared's:

>

If that is supposed to be an answer to my question:

>

It is not an answer to the question I asked. And, it has two other problems: 1. the same would be said of interest on corporate bonds, and 2. as another poster pointed out, the dividends WILL be taxed when they are withdrawn from the IRA, 401K, etc.

In fact, this is a problem if Bush gets his plan approved by congress. People holding their stocks outside tax deferred vehicles will get their dividends tax free, while those holding them in a retirement vehicle will have them (double) taxed.

In fact, this is a problem if Bush gets his plan approved by congress. People holding their stocks outside tax deferred vehicles will get their dividends tax free, while those holding them in a retirement vehicle will have them (double) taxed.

I'm going to be charitable and assume this is due to the slapdash way the program was assembled. "We doubled it in size last Friday!"

Actually, it doesn't like a bad idea for a corporate CEO to derive most of his earnings from non-taxed dividends. Unlike so many of the outrage inducing case that have become cliche this make the CEO's income highly dependent on the company's performance rather than its stock value.

I don't see this proposal as much of an immediate stimulus but it could have very positive effects on avoiding another period of insanity as we saw from the Tech Bubble. Under the current system there is little motive for informed individuals to make stable long term investments. They either must place their trust in a collective investment that isn't taxed (which into existence as a reaction to dividend taxes but require the investor to forsake their own judgement) or try to game the market. I don't feel that these make a satifactory range of choices for what is intended to be a nation of individual liberty.

Unlike so many of the outrage inducing case that have become cliche this make the CEO's income highly dependent on the company's performance rather than its stock value.

Yeah, directly paying the CEO cash out of the company treasury through dividends would be an improvement over paying the CEO cash out of the company treasury through stock options.

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