Stimulating Relief Kenneth Freije • The gift that keeps on giving April 2003

Budget deficits, a slumping economy, and of all things a tax cut. With the recent overseas turmoil, an important facet of the domestic policy advocated by George Bush has been all but pushed from public attention. As many major economic indicators remain weak, and the rhetoric of the cost of the war with Iraq grows louder, the issue of tax cuts still remains. The dividend tax cut proposed by George Bush some short two months ago has been vilified as a benefit meant only for the rich. Yet, what distinguishes a good economist from a bad one is whether he looks simply at one step beyond the economic decision being considered or several. Clearly the critics of the tax plan are looking only at the immediate consequences and fail to see the long-term effects of the plan.

Similar to the estate tax earlier repealed in George Bush’s administration, the dividend tax presents a clear-cut case of double taxation. Dividends are corporate profits that are paid out to shareholders. Before a corporation can distribute excess earnings to its stockholders, it must first pay a federal corporate tax rate of 34%, and then state taxes, which average about 7.5% of corporate profit. It is from this taxed income that a dividend is paid. The problem is, once a corporation pays its stockholders a dividend, this divided is then counted as ordinary income in the individual’s tax return. Therefore, the money already taxed at the corporate level is taxed again at the individual’s federal income tax rate.

No other investment is taxed in this way. The estate tax, a tax on assets passed from trustee to heir, was quickly abolished once the populace realized that the assets involved in an estate had been taxed as income during the lifetime of the benefactor. Returns on bonds and capital gains accrued from stock price increases are taxed only at the individual level. Interest payments on bonds, as well as the investment expenses incurred by share repurchases— a practice by which a corporation buys back shares of its stock and then removes them from the market, resulting in a stock price increase—are both treated as expenses at the corporation level, and thus not taxed. If the US tax code is to be consistent, the blatant double taxation inherent in the dividend tax must be stopped.

What of the complaint of the Democrats, that this tax will simply benefit rich investors? On first glance this is true. Most statistics point to the fact that in simple money terms, most of the money from the tax cut will initially benefit the wealthiest segments of society. But should it not be that way, given that they pay a disproportionately high percentage of the nation’s taxes? Since the 1980’s, when Ronald Reagan’s tax proposals phased out lower brackets and simplified the bracket structure, the wealthiest have been paying a larger and larger share of the taxes. So, it would seem natural, that they would reap the largest benefit of a discount on taxes (clearly, 4% of $10 million is way more than 50% of $500).

But even beyond that, it is just not true that only the rich will benefit from the tax-cut in the long-term. Twenty or thirty years ago, this claim would have been at least somewhat valid. Yet, since 1980 total mutual fund holdings alone have nearly increased sixty-fold. Forty percent of this increase in investment results from new individual investors, investors such as a retiree or a middle class family beginning a retirement savings plan. The theory that mutual funds and stocks are investment instruments reserved for the wealthy has long since passed. In fact, nearly 28% of all household discretionary saving—6.1 trillion dollars—was held in mutual fund shares.

Why are mutual funds so important? Most of the commonly held mutual funds are simply portfolios of stocks. More importantly, a great portion of the income that the common investor spends from mutual fund holdings is in the form of dividends, which have a close correlation to the dividends of the stocks in the underlying portfolio. The reason that investors spend dividends, and are less likely to spend the proceeds from equity increases is because a dividend can be paid directly into a savings or checking account. To utilize the value of a security price increase, investor must sell the stock or mutual fund. Not only is this difficult to do psychologically, every sell transaction carries a commission fee; this fee is absent from a dividend transaction. Some Democrats may claim that mutual funds—the primary equity holdings of the middle class—already have tax advantages that would not be affected by a dividend tax cut. On the surface, this is true. The mutual fund companies themselves do not pay corporate income tax on the 95% of income that they are required to distribute to their shareholders. Yet, the corporation that pays the dividend to the mutual fund company, is subject to tax at the corporate level, and the individual investor who receives a dividend from the mutual fund company is again taxed on the same income.

The prime beneficiaries of the tax decrease would not be the up-and-coming Wall Street professionals or the Fortune 500 CEO’s; in fact, the prime beneficiaries from the dividend tax cut would be those who are now living off the dividend income provided by their stock, pension, and mutual fund assets. Senior citizens, those depend on the dividend income paid from their individual retirement accounts, would see the most relief from a dividend tax cut.

Second, there is an added benefit to the economy as a whole from removing the burden of the dividend tax, even if at first it does mainly benefit the rich. How does this work? Most people who collect dividend income and do not need that income for their day-to-day expenses – like senior citizens do – end up reinvesting those dividends back into the company. It is easy, there is little paperwork that needs to be filed, and the investors do not have to pay brokerage fees and commissions on these transactions. This infusion of revenue into the stock market would be very helpful.

Beyond this benefit, however, is the idea that companies will now actually have an incentive to pay out the dividend rather than waste it on shaky investments. Previously, companies had little incentive to actually pay out their dividends. Much of the money paid out to investors would go to Uncle Sam anyway, and it would not provide a sufficient enough of an incentive for investors to invest in companies that are actually profitable. This is one reason why there was the so-called stock bubble in the mid to late 1990’s, when internet companies like eToys that were actually losing money, were the biggest darlings on Wall Street. Many bad investments were made in companies that were not – and could never be – profitable. Why? Because investors did not feel the difference between companies that were and those that were not making money. If the company was profitable – and hence paying dividends – their earnings were being taxed by Uncle Sam anyway. Elimination of this tax would discourage such bubbles, since investors will now have a real incentive to make good investments in profitable companies.

Related to this, is the fact that companies will also be less likely to engage in shady investment deals that have since gotten many of these corporations in trouble with Elliot Spitzer and the SEC. Companies that are not accountable to investors – by generating profits and paying out dividends – would lose investments to companies that are. Hence, they would be less likely to engage in risky schemes such as those uncovered at WorldCom and Enron over the past two years. Moreover, a company cannot fudge earnings data if it needs to pay out those earnings as dividends to the investors, or otherwise, they will not have enough money to pay out. Companies will be encouraged to pay dividends because investors will now feel a difference between dividend and no dividend, since the federal government will no longer take much of the money away from them.

All of this would encourage investor confidence. It would also encourage investment in real companies that actually make money and discourage bubbles that could be burst by one or two shaky economic indicators. This helps everyone, particularly the smaller investor because it is the smaller investor who is often most devastated by Previously companies had little incentive to actually pay out their dividends since much of the money would go to Uncle Sam anyway. bursting bubbles and corporate misdeeds. That’s not to say that such things will not happen anyway, but at least now, companies will suffer a real consequence if they do not actually turn a profit that they have to pay out in dividends.

This tax plan, originally proposed by investment guru Charles Schwaab at the economic forum organized by President Bush in Waco, TX is a terrific idea to stimulate investment and benefit everyone. While it is true that the rich will be the ones seeing the immediate benefits of the bill, the long-term effects are good for everyone, rich and poor. Americans need to look beyond the rhetoric of class struggle put forth by the Democrats and ahead to a booming stock market.

Kenneth Freije, Managing Editor, is a sophomore in Branford College.