This article, written in Fall 2012 in anticipation of potential dividend tax rate changes, discusses some brief thoughts regarding dividend tax rate theoretical considerations. Furthermore, these insights help shed light on the dividend tax discussion in my brief tax proposal.
Although it was raised from 15 to 20%, this rate is much less deleterious than it may have been. Whether dividend stocks can continue to excel in a yield-starved environment will be interesting to follow.
The Bush tax cuts resulted in a cut of more than just the income tax rate. It also lowered the dividend tax rate down to the same as the long-term capital gains rate, rather than taxing dividends at ordinary income tax rates.
The dividend tax is a second-layer tax, meaning that the shareholder pays the dividend tax on the dividends it receives from the corporation after the corporation also pays a corporate-level tax.
I often heard folks express concern over the potential reversion of the dividend tax rate back to ordinary income rates (raising dividend tax rates from approximately 15% to 40%) if the Bush tax cuts were not addressed prior to expiration.
Without giving an opinion as to the other taxes in that tax cut package, I do agree it was vital that dividend tax rates not be increased to previous levels.
First, interest rates at record-low levels already penalize savers. With a potentially suboptimal and unsustainable 70% of the U.S. GDP coming from consumption, the last thing we needed to do was to increase taxes on income derived from savings. Many traditional savers receive their less-risky investment income from interest and dividends.
With no opportunity to receive a reasonable rate of return from interest payments on fixed-income investments, dividends are vital to provide current cash flow for much of the population’s savings.
It would be unreasonable to further reduce the amount of income savers receive from their investments due to a dividend tax rate hike.
Second, dividends would less likely be issued by corporations because share buybacks would be encouraged, at the margin, over dividends. If the Bush tax cuts expired completely, tax rates on capital gains would be significantly below dividend tax rates. ‘
This differential in capital gains versus dividend tax rates results in a marginal incentive for management to deploy capital reserved for shareholders to be executed through share buybacks rather than dividend payments.
Folks may debate if that choice makes a difference, but it would seem appropriate that the decision is made for fundamental, rather than distorted for tax, reasons.
Lastly, globalization has increased the ease of capital mobility for dividend-seeking investors. Folks often complain the increased labor mobility stemming from globalization negatively affects U.S. workers. However, labor mobility has increased less than capital mobility as a result of globalization because it is easier than ever for investors to move their capital (it often just takes a click of a computer button!).
Accordingly, overly-increased dividend tax rates would discourage dividend-seeking investors both at-home and abroad from investing in U.S. corporations that provide jobs for many U.S workers.
No matter how one might feel about the income tax cuts for individuals covered in the Bush tax cuts, it is important for the populous to understand that income taxes were not the only tax cuts included in that package.
Regardless of what Congress did regarding the other tax cuts, dividend tax rates were, fortunately, not raised back to previous levels.