Dividend Taxes, Part I: A Primer; Double-Taxation

A primer (skip ahead if you know this):

Dividends are profits that are distributed to shareholders. If Angry-Bear-Tech (AB Tech) makes an after tax profit of $10m this year, the CEO and the board must decide what to do with that $10m. Some of it, say $1m, we may keep as cash, a rainy day fund. Some of it, say $3m, we spend on improving our infrastructure. We spend another $2m to acquire Honey Bees Inc.. That leaves us with $4m. One of the things we could do with this is distribute that $4m to the owners of the firms, the shareholders. Why would we do this? In principle, the Board represents the shareholders and will, acting in the shareholders’ interests, say give the shareholders that money! If there are 20 million shares of AB Tech outstanding, then that $4m has to be split $20 million ways, meaning each share has the right to $4,000,000/20,000,000=$.20. AB Tech will pay this out as a dividend of 20 cents per share. If you own 10,000 shares of AB Tech then you get a check for $2,000. Under current tax laws, that counts as income on your 1040, so you will have to pay taxes on that $2,000.

Of course, AB Tech’s pre-tax profits were above $10m, roughly $13m. So that $13m was taxed once and it brought the total down to $10m. Then it gets paid out as dividends, where it is taxed again as personal income. If the average tax rate of AB Tech shareholders is 25% then that $10m becomes $7.5m of after-tax income. At the end of the day, $13m in pre-tax corporate profits becomes $7.5m of after-tax profits in shareholders’ pockets. This is an overall tax rate of (13-7.5)/13=.423, a 42.3% effective tax rate on income received via corporate profits.

So is the problem really that dividends are taxed twice? All sorts of income are taxed twice. It’s taxed when I get my paycheck and then it’s taxed when I buy gasoline. It’s taxed when I get my paycheck and then taxed again when my landlord receives it as income. Should we really be counting the number of times something is taxed? What if it were taxed twice at very low rates? Is that better than taxing it once at a high rate? That part of the discussion is just silly.

Returning to the example above, do you really think the advocates of eliminating the dividend tax would be happy if the corporate income tax rate were increased to 42.3% (with no dividend tax)? Then the income would only be taxed once!

Another point rarely mentioned by the pro-cut side: if you own stocks in a 401(k) or Traditional IRA, then your dividends are not taxed when you receive them, but rather when you retire and draw upon the funds (this is tantamount to paying a lower rate. Paying taxes 10 to 30 years from now is a lot better than paying them right now). Dividend income from stocks held in a Roth IRA are never taxed. I’m not sure what proportion of stocks are held in these vehicles (angrybearblog@yahoo.com), but it is a substantial amount, probably in the neighborhood of 10-20%.

One more point for the time being, but there’s more to come. If you make less than $85,000 per year, as 80% of all households do, then it’s a pretty safe bet that the vast majority of your dividend income is in retirement accounts. The same is true, though to a lesser extent, for the 95% of households that make under $150,500 per year (see Money Income in the United States, 2001, p. 19). So for the majority of the population, dividends are not taxed or are highly tax-advantaged, so there is not really much of a double taxing.

So of the myriad intricacies and oddities in the tax code, this is the one we have to fix right now? Because it’s the one that causes about 5% of the population to pay an overall tax rate around 42% on income received from corporate profits?

But there are legitimate reasons why the dividend tax is problematic, but they are more subtle than “double taxing bad”, andthus not widely invoked by the proponents of eliminating the tax.