Bush's Dividend Tax Cut: Glass Half Empty or Half Full?Published: June 04, 2003 in Knowledge@Wharton
At the urging of a few academics and Wall Street executives, President Bush last fall proposed eliminating the income tax that investors pay on dividends. Advocates said the move would stimulate the economy, boost stock prices and discourage the bookkeeping games and excessive borrowing that have afflicted many public companies.
But the final tax-cut bill the president signed into law at the end of May was far more modest, merely reducing the dividend tax to 15%, from a high of 38.6%, for investors in the top tax bracket.
Is that enough to provide the benefits advocates had predicted? “The measure is better than what we had – it’s better than nothing,” says Wharton finance professor Jeremy Siegel. “But it certainly isn’t as strong as our proposal would have been.” Siegel had called for eliminating the tax that corporations pay on profits turned over to shareholders through dividends.
Cutting taxes is generally good for the economy over the long term, he says. But he predicts that the dividend tax cut will not provide the side benefits he and two colleagues described in a column last August in the Wall Street Journal. In that column, Siegel, Wharton finance professor Andrew Metrick and Harvard finance professor Paul Gompers outlined five benefits of eliminating the tax that corporations pay on profits paid out as dividends.
· Encouraging companies to raise money by selling stock rather than bonds
· Discouraging bookkeeping gimmickry to enhance reported profits
· Reducing the use of stock options for employees and managers.
· Reducing the incentive for companies to move overseas to escape U.S. taxes
· Reducing incentives for companies to pack employee 401(k) plans with their own stock.
A similar case was made by Charles Schwab, head of the brokerage firm that bears his name. Critics have long lamented the “double taxation” of corporate profits – once by the company and again by the shareholder receiving dividends. Bush immediately embraced the idea.
But to make it more politically palatable, he proposed to instead eliminate the tax that investors pay on dividends they receive in taxable accounts, while continuing to tax profits at the corporate level. Most advocates of tax cuts found this an acceptable tradeoff.
This spring, however, the president was forced to scale back the proposal as it became clear Congress would require a smaller tax-cut package. Democrats, and some Republicans, worried the president’s initial plan would be too expensive and would favor the affluent.
Even the affluent were not unanimous in their support of the dividend-tax cut. Indeed, Berkshire Hathaway CEO Warren Buffett strongly opposed the cut in a May 20 Washington Post opinion column. “If enacted, these changes would further tilt the tax scales toward the rich,” Buffett wrote.
Under the previous tax rules, Buffett and his office receptionist each paid about 30% of their income in federal taxes, he said. Eliminating the dividend tax might encourage Berkshire Hathaway to start paying a dividend, he argued. If the annual dividend were $1 per share, he would receive $310 million in additional income, tax-free. This would reduce his effective tax rate to 3%, while his receptionist would continue paying 30%.
“Administration officials say that the $310 million suddenly added to my wallet would stimulate the economy because I would invest it and thereby create jobs,” Buffett wrote. “But they conveniently forget that if Berkshire kept the money, it would invest that same amount, creating jobs as well.”
If the goal is to stimulate the economy, he said, it would make more sense to reduce taxes for “those who both need and will spend the money gained … Enact a Social Security tax ‘holiday’ or give a flat-sum rebate to people with low incomes. Putting $1,000 in the pockets of 310,000 families with urgent needs is going to provide far more stimulus to the economy than putting the same $310 million in my pockets.”
The final package, signed into law at the end of May, reduces dividend and long-term capital gains taxes to 15% percent for most investors. Previously, dividends were subject to income taxes at rates as high as 38.6%, while capital gains on assets owned for more than a year were taxed at 20%. The package also slightly reduced income-tax rates.
How will this affect the five goals Siegel, Metrick and Gompers had outlined?
Reducing excessive debt: Siegel and the others argued that the previous tax law encouraged companies to borrow by selling bonds because interest payments to bond holders were tax deductible. Companies could also raise money by selling new blocks of stock. But since dividend payments to shareholders were not tax deductible, the company preferred issuing bonds and getting the tax benefit. Siegel said eliminating the corporate tax on dividends would make stock a more attractive means for raising money, reducing companies’ excessive reliance on borrowing. Huge debts have driven many companies to bankruptcy during downturns.
The final measure, says Siegel, leaves the corporate dividends tax intact. So debt remains the preferable way to raise money. “The incentive for managers to use dividends is not high,” he said. “It goes in the right direction but certainly does not put equity and debt on an equal footing.”
Reducing accounting games: Again, Siegel believes the final measure will be of little help. The scandals at Enron and other companies over the past two years have largely been driven by executives’ efforts to inflate reported earnings. They did this because, under the previous tax law, capital gains were taxed at much lower rates than dividends. Thus, shareholders preferred to receive their profits via stock-price gains, which are driven by growing profits – or the illusion of growing profits. Earnings were thus reinvested or used to buy back shares – strategies for raising stock prices.
With the dividend tax eliminated, investors would prefer to receive profits via dividend payments. There would be less reason to inflate earnings. In fact, earnings statements would have to be accurate, because companies would need to have cash to make dividend payments.
Merely reducing the dividend tax does not change the incentive to emphasize stock gains rather than dividends, Siegel says. The capital gains tax has also been reduced to 15%, blunting the edge dividends would have enjoyed because of the dividend-tax cut. Investors are still likely to prefer receiving profits from capital gains rather than dividends because gains tax is levied only after an asset is sold, while dividend tax must be paid the year the dividends are received.
“They certainly gave the dividend a nice break,” Siegel says. “But then they took part of that break away by giving the break to capital gains.”
Reduce stock options: Critics argue that excessive use of options has caused executive compensation to skyrocket and encouraged accounting shenanigans. Executives and employees who hold stock options can make large profits if stock prices rise and they exercise their options to buy shares. But options holders do not receive dividends. Had the dividend tax been eliminated, more companies would have increased dividend payments, making options less attractive.
Since the final tax-cut measure does not make dividends more desirable than capital gains, it will do little to reduce use of options, Siegel suggests.
Moving overseas: Many companies have moved operations to foreign countries because profits earned overseas can escape corporate income tax in the U.S. Siegel and his colleagues argued that with the dividend tax eliminated, companies could have escaped tax on U.S.-based operations by simply paying those profits out through dividends.
But the benefits of operating overseas survive under the new tax law. “It unfortunately did not help,” Siegel says.
Reduce company stock in 401(k)s: Many companies use their own stock to match employee contributions to 401(k) plans. One reason is that under the old law dividends paid on shares held in 401(k)s were tax deductible, even though dividends paid on stocks held by ordinary investors were not. As a result, employees at Enron and many other companies had excessive holdings in company stock, suffering devastating losses when the stocks collapsed.
Making all dividend payments tax exempt would eliminate the incentive to pack employee accounts with company stock.
“Unfortunately, again, there is a problem here,” Siegel says. “Because dividends are not deductible at the corporate level, unless they are paid into a 401(k) plan, the incentive [for a company] to put [its] stock into a 401(k) plan is still there.”