Warning: Obama Proposes Tripling Dividend Tax Rate
In the summer of 2008, the Obama campaign's two top economists proudly proclaimed that their candidate favored a dividend tax rate of 20 percent, "lower than all but five of the last 92 years." Well, that was then. In a sharp break from that campaign stance and the Administration's first three budgets, President Obama is now calling for an all-in dividend tax rate of almost 45 percent, the highest rate in 27 years. The president's about-face bodes ill for the economy.
While the president's proposal raises dividend tax rates only on high-income stockholders, Americans at all income levels will feel the economic impact of the tax hike. Higher dividend taxation will impede the investment that fuels long-run growth, depress stock prices, and weaken incentives for good corporate governance.
The president's proposal would allow the 2003 dividend tax cut to expire for high-income households at the end of the year, pushing the top dividend tax rate up from 15 to 39.6 percent. That's a dramatic increase in its own right. But, other provisions make the true increase even larger. The president also wants to bring back a provision phasing out deductions for high-income taxpayers, which will cause each additional dollar of dividends to trigger 1.2 cents of extra taxes. And, beginning next year, the president's health care law will impose an additional 3.8 percent tax on dividends and other investment income of high-income households. Under the president's proposal, the top all-in dividend tax rate will be 44.6 percent - almost triple today's 15 percent rate.
Dividend taxes were lowered in May 2003 to reduce the tax penalty on investment, especially stock-financed investment. The president's new proposal would move us in the opposite direction. Raising the dividend tax will hamper investment, eroding the capital stock and slowing long-run economic growth. A smaller capital stock makes workers less productive, holding down their wages.
Higher dividend taxes also encourage more corporate borrowing. When a corporation issues stock to finance new investment, today's tax system imposes two levels of tax-the corporate income tax plus the dividend tax paid by the stockholders. But, when a corporation borrows, there's only one level of tax because the corporation can write off its interest payments.
The lower dividend tax rate has helped undo part of this pro-debt bias by giving stockholders a tax break at the individual level. In last year's budget, the Obama administration noted that the lower dividend rate "reduces the tax bias against equity investment and promotes a more efficient allocation of capital." Unfortunately, that insight is not reflected in this year's budget. While the president's new corporate tax reform framework rightly denounces the tax system's favoritism toward debt and even urges Congress to "consider" trimming corporations' writeoff for interest payments, his proposal to hike dividend taxes tilts the playing field back in favor of debt.
The dividend tax hike will also undermine good corporate governance by prompting firms to reduce dividend payouts. As economists Raj Chetty and Emanuel Saez have documented, the 2003 dividend tax cut induced firms to pay more of their earnings out to stockholders. After holding roughly constant near $25 billion from 1998 to 2002, annual dividend payouts rose following the 2003 rate reduction, reaching $33 billion a year by 2005. The number of corporations paying regular dividends surged after the tax cut. Increased dividend payments make it harder for management to hide a company's true financial condition or divert corporate funds to their own pet projects. The president's dividend tax hike will undo the recent progress on this front.
It's unfortunate that President Obama, after spelling out the case for low dividend taxes so clearly, has now reversed direction on this important issue. Perhaps, the president is trying to turn out his base on Election Day by appealing to their concerns about the gap between rich and poor. Regardless, Congress will need to address this matter before the 2003 dividend tax cut expires. We urge Congress to promote long-run economic growth by moving the tax system toward lower taxes on investment.