Thank you for the opportunity to testify on the President’s proposal to eliminate the double taxation of corporate dividends.
The proposal is sound tax policy. Let me say what the proposal will and will not do. Like all steps toward a better-balanced tax system, it will be resisted by those who have adapted to the distortions in the current tax code. Some will claim that it is not stimulative (an incorrect assertion) while others will claim that few are affected by tax provisions on dividends. Still, others will claim that it will raise the deficit and raise interest rates and thereby be counterproductive. I would like to address all of these issues and suggest the positive reasons why eliminating the double taxation of dividends is an excellent investment for the federal government to undertake.
Problems with Current Policy
The current double taxation of dividends has produced three types of behavior that penalize growth. First, double taxation encourages overreliance on debt finance by corporations. Debt finance requires firms to meet rigid debt service payments, whereas equity finance enables firms to pay a flexible stream of dividends, thereby making it easier to deal with unstable cash flows during business cycles.
Second, the double taxation of dividends encourages management to retain cash inside the corporation rather than pay it out. New technology companies that experience a surge in cash flow may not be, as we have seen, the best judges of the need to further expand capacity. Elimination of the double taxation of dividends puts pressure on management to pay out cash to investors and allows those investors to decide if they want to reinvest in that firm or invest elsewhere where prospective growth may be more promising.
On this second point I am surprised that so few commentators on the dividend taxation proposal have noted the connection between corporate scandals and the high level of cash retention in what were the fastest growing companies during the stock market boom. High levels of cash retained inside the company lead to the temptation not only to invest too much in a given area, but to make loans to corporate insiders on overly generous terms. The rationale for such insider largesse is usually the idea that if the head of the corporation were forced to sell stock, it would depress the stock price and thereby impede the growth of the company. That line of thinking has led to disastrous consequences for some of the fastest growing companies of the late 1990s.
Some in Congress have criticized the President’s proposal to end the double taxation of dividends because they say that few of their constituents receive dividends. This is like observing on a sunny day that few people are using umbrellas. Double taxation has indeed reduced dividend payouts and so fewer people are receiving dividends. The ratio of dividends as a percentage of earnings has fallen from about 60 percent in 1995 to about 40 percent in 2001. An end to the double taxation of dividends would mean more dividend payouts, thereby increasing the constituency for better tax treatment of corporations.
How Would Eliminating the Double Taxation of Dividends Increase Growth?
Higher after-tax returns for investors receiving dividends would increase the price they would pay for stocks of companies paying dividends. For those companies, the cost of capital would fall, they would invest more, add to the capital of stock, increase the productivity of their workers, and pay their workers higher wages. The overall stock of capital would increase while the composition of the capital stock would be improved by virtue of the removal of the distortion that generates too much capital of companies that rely heavily on debt.
Once again, the experience of the last several years is testimony to the advisability of reducing overreliance on debt while simultaneously encouraging companies to pay out earnings to investors. The increased pressure to pay out earnings results in a higher hurdle rate for investment with retained cash and thereby helps to avoid the excessive buildup of capacity in industries that may be experiencing a period of rapid growth the benefits of which ought promptly to be shared with owners of the companies’ stock rather than husbanded inside the company.
The desirability of eliminating the double taxation of dividends is hardly a novel concept. It is advocated in nearly every textbook on public finance and practiced, at least partially, in most major industrial countries. Indeed, the maximum effective tax rates on dividends are higher in the United States than in any of the G7 countries.
Larger Budget Deficits?
Any measure that reduces taxation results in the short run, at least, in a lower level of government revenue. By undertaking tax reform measures such as the elimination of the double taxation of dividends, the federal government is, in effect, utilizing its borrowing power to invest in a better functioning economy by reducing distortions and burdens created by the tax system. Based on static revenue measures, elimination of the double taxation on dividends calls for the federal government to borrow about $300 billion over ten years in order to finance a measure that reduces distortions, increases stock prices, and results in a higher capital stock and higher real wages. As such, the net cost of the measure will be considerably less than the initial estimate of revenue lost. Indeed, over a long time horizon, investment in measures to reduce distortions in the tax system ought to be self-financing.
That said, there is no denying an additional supply of government securities, say over the first five years of the program, which are estimated to be $132 billion. The addition of $132 billion over five years to a pool of debt including government, corporate, municipal, and mortgage debt in the United States totaling about $18 trillion currently is hardly likely to produce an impact on interest rates. Indeed, in the current environment of excess capacity in some industries, one might hope that tax measures could be found that would result in higher interest rates, not through crowding out but, rather, by generating
higher real returns on capital. Such higher real returns would require higher real interest rates on other investments such as U.S. government bonds to compete with the enhanced attractiveness of investments in new industries.
Elimination of the double taxation of dividends constitutes low-hanging fruit in the tax reform area. It would be an excellent start down the road to full elimination of the tax on corporate income and a movement toward an integrated tax system where corporate income is imputed to its ultimate owners—households—and taxed once at that level at the same rate that all income is taxed. That would be real tax reform. It is time we return to that important agenda, begun in 1986 with the support of many members—in both parties—of this distinguished committee.
John H. Makin is a resident scholar at AEI.