Dividend tax cut proposed

Judging from recent reactions to President Bush’s tax reduction proposals, it appears some are applying the sentiment of former Sen. Russell Long: “Don’t tax you, don’t tax me, tax the guy behind the tree.” Even when talking about tax cuts, agreement is difficult because of the fear that some may benefit more than others, or that some groups or even the overall economy may be harmed.

But there is one part of the president’s package that most Americans, both Democrats and Republicans, should be able to agree on. Under our current tax system, corporate earnings are taxed twice – once at the corporate level and then again when earnings are paid out to shareholders as dividends. The president has proposed that the second tax be eliminated.

Elimination of the tax on dividends would move the tax system towards the principle that income should be taxed only once – a principle that most people would agree with on grounds of simple fairness. In addition, most economists have long held that the double taxation of earnings has a distorting effect on the economy, encouraging corporate debt at the expense of equity financing and reducing capital accumulation and investment. Doing away with double taxation would therefore lead to greater efficiency and productivity.

The main argument of those opposed to the president’s tax cut package is that it would lead to higher deficits and do little to stimulate a sluggish economy. This argument, however, does not apply to a tax cut on dividends because it would provide an economic boost at a relatively low cost in lost government revenues.

The immediate impact of eliminating the tax on dividends would be an annual tax savings of roughly $30 billion, or .3 percent of gross domestic product. These savings would be distributed broadly and shared by the more than 50 percent of U.S. households that own stock. When a portion of that $30 billion is spent, it would become additional income for others and, through the multiplier effect, result in additional increases in GDP. The multiplier applies to most tax cuts or increases in government spending.

The $30 billion in tax savings is actually a very conservative estimate because it assumes no change in the current dividend policies of U.S. companies. But it is likely that more companies would issue dividends. Now that a tax cut on dividends has been proposed, companies that have previously retained large amounts of cash have said they may distribute some of that cash to shareholders.

As useful as a tax cut on dividends would be in reviving a sluggish economy, the main benefits would be long term. The double taxation of corporate earnings reduces companies’ return on capital and therefore increases the cost of capital. Lowering the cost of capital by eliminating taxes on dividends would encourage companies to invest more in plants, equipment and other capital stock, enhancing long-term growth and leading to more jobs and higher wages.

After the excesses of the late ’90s there is clearly something to be said, from the standpoint of both shareholders and the health of our economy, for encouraging companies to concentrate on genuine earnings. Stock ownership is ultimately a claim on a company’s future stream of earnings. Without earnings, an investment in a company becomes no different than a bet in a casino – a phenomenon that became all too common during the recent bubble.

Encouraging companies to pay dividends would limit excesses because dividends offer proof of actual profits. Companies with real profits may, of course, choose not to pay dividends, but those that do provide investors with valuable information on the company’s financial health and future prospects. No company can pay dividends for long without earnings to support them.

Congress and regulatory bodies such as the SEC and the New York Stock Exchange have taken a number of steps in the past year to protect the interests of investors and restore confidence in our capital markets. Elimination of the double taxation of shareholder dividends is an essential further step. It would encourage sound financial management, provide investors with more of the information they need to make wise decisions and put a greater focus on earnings and rewards for shareholders. It would help stimulate growth and strengthen our capital markets. It is a tax cut that benefits all of us.

Benjamin P. Smith is vice president and branch manager for Morgan Stanley in Portland. Morgan Stanley and its financial advisers do not provide tax or legal advice.