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Wednesday, January 15, 2003

Dividend Tax Permutations-Part II-Apologies to Krugman-In part I, I had implied that Krugman was making up the plan
Please note, before we go further, that there doesn't seem to be anything I've seen come out of the White House that would indicate anything more that a straight dividend exemption. No corporate tax tests. No exemptions for retained earnings. If Krugman and others have a copy of the plan that does, let me know
Well, here it is, straight from the Treasury Department web site.
• When a corporation is taxed on its income and later pays dividends that are taxable to shareholders, this effectively results in the same income being taxed twice. This double taxation of corporate earnings distorts business decision-making and is inefficient. To eliminate the distortion and inefficiency, dividends should be excluded from income if the dividend income has been taxed at the corporate level.[italics added]
Only if earnings have been taxed will it be available for a dividend exemption. I owe my favorite Keynesian foil an sincere apology. How would this change things from a straight dividend exemption? There would have to be an extra column in corporate 1099 forms telling investors how much of their dividends are taxable. Companies that are making use of depreciation and other tax deductions to the extent where they aren't paying any income tax will have their dividends taxable while companies that are paying taxes would be at least partially tax-exempt. What will this mean for investors? We'll be introduced to a new acronym, the EDA, or excludable dividend account. That's the already-taxed income eligible for a tax-free dividend. One could picture high-tax-bracket taxpayers flocking to companies that have high EDA balances. The mutual fund industry would set up EDA stock income funds to provide tax-free dividend income for high-tax-bracket investors. Tax exempt/deferred or lower-bracket investors would then tend to gravitate towards non-EDA dividend paying stocks, for the EDA companies prices would tend to be bid up to the point where the yields of EDA companies are about 30% less than the yields on non-EDA companies. What would this mean for politics and corporate tax policy? It would tend to decrease the value of accelerated depreciation and other tax shields, especially for mature, dividend-paying companies. There would be an added emphasis on trimming tax breaks for corporations, especially for utilities and banks, who tend to be the biggest dividend-payers. The non-EDA companies would be targets for bashing from liberal tax-fairness outfits. What would this mean for the economic impact? It would be a boost for companies who don't get a lot of tax breaks, while it would tend to hurt companies who pay dividends but don't pay much in taxes. Service industry companies will be better off than manufacturing companies, for accelerated depreciation on plant and equipment will cause manufacturers to have more non-EDA profits. This will increase the relative value of labor and reduce the relative value of new equipment, as the after-tax return for labor-based projects (including "knowledge-worker" based tech firms) will be increased in the new system more than the return on equipment-based projects. Is this still worth fighting for? Given that it will add complexity to the personal finance markets while being inadvertently selective in what firms will be aided, this might not be worth going to the mat for. The beneficiaries are high-tax-bracket taxpayers (who would have EDA mutual funds to provide tax-free dividend income) and high-labor-to-capital-ratio companies who don't have as much depreciation to write off. We might have smart paleocons who will see that this might help drive manufacturing jobs overseas and join the liberals in fighting this. The president might be better off fighting for reductions in tax rates and quietly offer to kill this proposal as a sacrificial lamb to the left.

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