President Bush has announced that he will introduce legislation
eliminating income tax on stock dividends. This is a bad idea,
for the following reasons:

1. It gives the tax exemption to the wrong entities.

If corporations are to be encouraged to pay dividends, make dividends
tax deductable to corporations. This would encourage corps in the
position to pay dividends more likely to do so, and encourage ones that
already do so to have both better cash positions (due to lower taxes)
and pay higher dividends.

Dividends are so low nowadays that the tax exemption isn't going to
dramatically help many individuals, particularly since so many people
own stock in tax-deferred devices like IRA's and 401-K's (more on this
later...)

Maybe giving the exemption to corporations is bad politics at the
moment, but if the "double taxation" of dividends is what is to be
addressed here, it makes the most sense to give corporations the tax
writeoff.

2. What about IRA's/401K's?

Currently, what you withdraw from a IRA/401K is taxed as ordinary
income, unless it is from a Roth, in which case it is tax-exempt. What
about dividends from a stock in a 401K? Is this going to be taxed as
ordinary income as well? In other words, it may now be advantageous to
own dividend-yielding stocks _outside_ of an IRA/401K if dividends
aren't taxed.

So, what do the tax pros think?

--Foobarista

Currently, what you withdraw from a IRA/401K is taxed as ordinary
income, unless it is from a Roth, in which case it is tax-exempt. What
about dividends from a stock in a 401K? Is this going to be taxed as
ordinary income as well? In other words, it may now be advantageous to
own dividend-yielding stocks _outside_ of an IRA/401K if dividends
aren't taxed.

If dividends are no longer taxed to the recipient, then the advantage of holding dividend-producing assets in a retirement fund becomes a disadvantage, similar to the current disadvantage of holding bonds which produce tax-exempt interest in a retirement account. Ah, the joys of tax planning.

Phil

I think I would rather have dividends exempt on the corporate level, not at the individual level. This would better match the REIT treatment, as well as benefit those of us who have "tax favored" accounts (403(b), Roth IRA, etc.)

If the dividends become exempt at the individual level, it would benefit only those who own dividend paying stocks in a personal (taxable) account, but it would do nothing to encourage investing in tax-favored accounts because dividends inside tax favored accounts would still be double-taxed (taxed at the corporate level and again when we working stiffs retire and take money out of our 403(b) and similar plans).

If one wanted to stimulate the stock market, something that benefits both the 403(b) investor and those making personal (taxable) investments would likely have more of an impact than just the personal investors.

...Dividends are so low nowadays that the tax exemption isn't going to
dramatically help many individuals, particularly since so many people
own stock in tax-deferred devices like IRA's and 401-K's (more on this
later...)

I disagree. In 2000, (the most recent year for which data are published) there was $142billion of dividend income reported on 34 million individual income tax returns. That averages out to $4000/return or a probable savings of more than $1000 for someone in the 27% tax bracket. If you consider all returns, there were 129 million returns or about $1100 of dividend income per return. This is not a small number.

...Currently, what you withdraw from a IRA/401K is taxed as ordinary
income, unless it is from a Roth, in which case it is tax-exempt. What
about dividends from a stock in a 401K? Is this going to be taxed as
ordinary income as well? In other words, it may now be advantageous to
own dividend-yielding stocks _outside_ of an IRA/401K if dividends
aren't taxed. ...

So what? Tax laws change and investment strategies change to keep pace with the changes. It's a recurrent theme. Now IRAs will be used for shorter term investments. It's possible that some people may discover that they will do better keeping their retirement assets out of tax-sheltered vehicles.

Ira

I disagree. In 2000, (the most recent year for which data are published) there was $142billion of dividend income reported on 34 million individual income tax returns. That averages out to $4000/return or a probable savings of more than $1000 for someone in the 27% tax bracket. If you consider all returns, there were 129 million returns or about $1100 of dividend income per return. This is not a small number.

But you are making the communistic assumption of flat income
distribution :) In any case, in this sense it is actually more fair to
have corps have the tax deduction, so that the actual dividend is
likely to be bigger (which benefits everyone, including people who have
dividends accruing in a 401K or whatever) as opposed to pushing the tax
benefit to individuals but leaving the actual amounts the same.

--Foobarista

That averages out to $4000/return or a probable savings of more than $1000 for someone in the 27% tax bracket.

It's instructive to look more closely at the numbers.

From an article on moneycentral: a small group does take in a big chunk of the nation's dividend income. Only 6.5% of all the taxpayers declaring dividend income claim more than 41% of all dividend income declared.

Combining Ira's numbers with these, 2.2 million taxpayers (6.5% of 34 million returns showing dividend income) are reporting almost $65 billion in dividends (41% of $142 billion). So for these fat cats, it averages out to almost $30,000/return. These lucky folks are likely to be in the 35% and 38.6% brackets - let's be generous and say 36.5%. That works out to be more like $11,000 apiece!

Of course, the Republican response to this will be that these guys - the wealthiest taxpayers - are now paying the bulk of the taxes, so they should get the bulk of the relief - and there's a certain amount of logic to that argument.

I don't know what the answer is. Maybe they should consider reverting to the way it was not too many years ago, when the first $200 in dividend income was excused from taxpayers. That throws a smallish bone to a lot of taxpayers.

Lorenzo

me: I disagree. In 2000, (the most recent year for which data 
are published) there was $142billion of dividend income reported on 34 
million individual income tax returns. That averages out to 
$4000/return or a probable savings of more than $1000 for someone in 
the 27% tax bracket. If you consider all returns, there were 129 
million returns or about $1100 of dividend income per return. This is 
not a small number.

Foobarista: But you are making the communistic assumption of 
flat income distribution :) ...

me: Fair criticism... perhaps. Here's the actual distribution:

     AGI        # returns   # Div returns   Dividends    Div/return
     ($)        (000,000)     (000,000)     ($000,000)     ($000)

total            129.3          34.1          142.2         4.17
under 15K         38.6           5.5            6.6         1.2
15K-<30K          30.1           4.4            8.3         1.9
30K-<50K          24.0           5.6           11.6         2.1
50K-<100K         25.7          10.7           27.3         2.6
100K-<200K         8.1           5.4           27.2         5.0
200K+              2.8           2.4           61.3        25.5

As expected, the distribution of dividend $ is skewed toward the 
wealthiest taxpayers as is the percentage of returns at a given AGI 
level that include dividend income. However, it's interesting to note 
that as a percentage of AGI, dividend income is as significant for the 
lowest income bracket as the highest, running at ~10% of AGI.

Ultimately, the tax code is financial social engineering. It won't ever 
be "fair" or optimal.

Ira

BTW, Anybody know how to mix proportional and fixed-width fonts in the 
same message?

BTW, Anybody know how to mix proportional and fixed-width fonts in the same message?

That would have to be done with HTML codes. Be sure to click on PREVIEW before posting when using HTML codes! It's way too easy to mess up.

For tabular ("pre-formatted") data, the <PRE> tag at the beginning and the </PRE> tag at the end of the table will do. For example:

me: Fair criticism... perhaps. Here's the actual distribution:
<PRE> tag here:

     AGI        # returns   # Div returns   Dividends    Div/return
     ($)        (000,000)     (000,000)     ($000,000)     ($000)

total            129.3          34.1          142.2         4.17
under 15K         38.6           5.5            6.6         1.2
15K-<30K          30.1           4.4            8.3         1.9
30K-<50K          24.0           5.6           11.6         2.1
50K-<100K         25.7          10.7           27.3         2.6
100K-<200K         8.1           5.4           27.2         5.0
200K+              2.8           2.4           61.3        25.5
</PRE> tag here:

The actual <pre> and </pre> tags won't be visible--I had to do some palming to get them to magically show up.

Thanks. I knew there was a way, having seen others do it, but when I used the check box, it changed all of the text.

Ira

So, what do the tax pros think?

I think I have enough to do to keep up with the things Congress has actually passed and the President has actually signed. Plus all of the Treasury Regulations, Revenue Rulings, Revenue Procedures, Letter Rulings, and other authorative literature.

I don't have too much time to fret over legislation that is so far away from passing that major provision are not yet generally agreed upon.

Once the details are worked into a bill that can be passed and signed, the tax planning will be fairly obvious. Until then, I've got organizers to print, appointments to schedule, tax update classes to attend and an office to organize for tax season.

--Peter

Getting rid of the tax on dividends at the personal level isn't a bad idea -- it just isn't the *best* idea.

I'm personally in favor of allowing a corporate deduction for dividends paid. Corporations already are allowed to deduct interest expense. Allowing the deductibility of dividends would get rid of some of the bias towards debt. It would also go a long way towards making the US corporate income tax system more competitive with systems around the world, which would make the US a much more attractive place to have headquarters and do business.

There are quite a few other advantages of deductibility at the corporate level, but I won't get into it now.

Good article in today's NYTimes on possible consequences of dividend tax elimination (probably not considered in advance of making proposal, he says, beating Phil to the tax legislation cynicism draw). Without further analysis, it looks to me like most of these consequences (such as raising the cost of borrowing for states and municipalities) would be minimized if "double taxation" on dividends were eliminated at the corporate not individual level.

http://www.nytimes.com/2003/01/07/business/07PLAC.html

For everyone who agrees with my opinion about where the double-taxation on corporate dividends should be eliminated, and especially those who disagree, and those with opinions about the Growth and Jobs Plan (formerly known as the Economic Stimulus Package), may I suggest an age-old activity? Write to your congresscritters!

This link can look up your state and federal representatives, and even allow you to send them e-mail:

http://congress.org/congressorg/dbq/officials/

This evening I will be starting my letter to my President, my two Senators, and my Congresswoman. I will try to present my thoughts in a conceise, neat fashion (I am aiming for one page, bulleted points), spell-checked, and easy to read.

I might not have economic knowledge to formulate a complete plan, but I plan on having four aids to my federal elected officials know that I have an opinion. Anyone with a $0.37 stamp (or, in my case, a $0.34 + three $0.01 stamps), or anyone with an e-mail address, can do likewise!

--Mark
who often heard his parents often joking about each cancelling out the other's vote!

So for these fat cats, it averages out to almost $30,000/return. These lucky folks are likely to be in the 35% and 38.6% brackets - let's be generous and say 36.5%. That works out to be more like $11,000 apiece!

How many of them actually have their $30K of dividends and another $15K of Social Security, and nothing else?

3. Muni effect. Since dividend paying companies (and there will be more of them) are understood to be "safe", more people will allocate money that is now in municipal bonds to dividend paying stocks. This will raise rates on munis causing state and local finance costs to rise (just when thay happen to be broke).

4. Distortion of investment allocation. People will now have to allocate further between tax-deferred and taxable accounts. This is confusing to many people and will cause the mutual fund industry to create all sorts of new funds to allow investors to take advantage of it.

5. It will encourage some bad corporate decisions in some cases. In the extreme case, companies would be encouraged to distribute all profits as tax-free dividends, and only reinvest in their business using newly injected investment capital.

6. Companies with large amounts of cash would be under great pressure to disribute much of it tax-free. What if Microsoft has been waiting to make a great acquisition at a great price, but comes under great pressure to distribute most of its $40B stash ?

7. Possible sudden inflow of cash (M3??) may cause inflation to spike. Not a particularly great danger, but I < B>do expect inflation to begin rising just after the election in 2004 and expect rates to begin rising as well in 2005+.

I suggest that a better plan would be to equalize dividend and LTCG tax rates and holding periods. After all a dividend and a LTCG are very similar (retained cash versus 'retained' investment value). I would also strongly support a declining DIV/LTCG rate with increasing holding periods. Perhaps starting at 20% for a 1 yr. holding period and going down by 1% for every additional year until it reaches 10% after 10 years.