When the Republicans gained control of the US Senate last November, a heated debate broke out among political insiders. Should Republicans take advantage of their control of government to aggressively pursue their economic agenda? Should they spend 2003 trying to pass a major tax change? Or should they be, as President George W. Bush's father was, politically cautious and focus instead on maintaining the status quo that, after all, led to their electoral victory. Should politics trump policy?
Bush revealed his approach yesterday, and it is a bold one. For this Bush, the best defence is a strong offence. He presented an economic plan that included a centrepiece--a total repeal of taxation of dividends at the individual level--that would mark a dramatic change in the US tax code.
Why cut the dividend tax? The arguments are many. First, the US double-taxes corporate income. When a US firm earns a dollar, it pays 35c tax on that dollar. When it delivers the residual to shareholders in the form of a dividend, then the shareholder pays income tax on the dividend.
Most shareholders pay a 35 per cent tax. Since these taxes pile up upon each other, dividend income is the highest taxed form of income in the US. When economists wax poetic about tax reform, they almost always begin with the observation that the best place to start is to lower the highest tax rate.
Lower dividend taxes should have a number of beneficial effects. Since dividends are suddenly worth more after tax, individuals should be more willing to purchase equities of firms that are likely to deliver healthy dividends. The scholarly literature suggests that this effect could be substantial, with an increase in the value of US equities of about 8 percentage points around the midpoint estimate of the impact of the plan on markets.
The indirect benefits may be more important. When taxes on dividends are high, firms retain earnings in an effort to help shareholders avoid costly taxes. As Americans learned too painfully during the recent corporate scandals, the resulting cash hoards can be tempting to unscrupulous managers. If the Bush plan passes, firms will have a much stronger incentive to pay dividends to the rightful recipients.
Finally, the present US regime gives too big an advantage to debt finance because interest payments are deductible to firms, but dividends are not. The Bush plan will reduce this bias, and that would be likely to lower the overall debt levels of US firms. If that is accomplished, then firms will be significantly less risky, and bankruptcies will become rarer.
So ending the double taxation of dividends is quite sensible, which explains why it has been a hot policy idea in wonkish circles for years. The Democrats, however, are not amused. They believe that dividend tax reductions give too much of a tax cut to the wealthy, who own a disproportionate share of US equities. Democrat Charles Rangel, for example, said that the Bush proposal was an assault on the middle class to benefit the wealthy.
Perhaps, but this plan is one that has sound economic reasoning behind it. Indeed, the reasoning is so sound that most of the industrialised world--such as Australia--has some form of relief for double dividend taxation. Even the Scandinavians are doing it.
Which will make the coming debate over the Bush plan quite interesting. If the Democrats stick to their guns, then they will expose themselves to ordinary voters as radicals far to the left of European socialists, a fairly impressive feat.
If that occurs, then sound policy might be very good politics for the Republicans indeed.
Kevin A. Hassett is a resident scholar at AEI.