Dividend Tax Relief: Long Overdue

President Bush unveiled a tax package Tuesday that will include a substantial cut in the taxation of dividends. A dividend tax cut would boost the stock market, lessen the tax code bias against savings, and reduce incentives for firms to take on too much debt and to excessively retain earnings.

The tax plan tackles the problem that corporate earnings distributed as dividends may face both the 35 percent corporate income tax and the individual income tax, which has a top rate of 38.6 percent. This "double taxation" leads to a combined marginal tax rate of up to 60 percent on dividends. By contrast, interest is deductible to the corporation and thus only faces taxation at the individual level.

This problem is not new, but it is surprising that policymakers have taken so long to address it. After all, most other industrial countries have partly or fully solved the problem with various forms of dividend tax relief. Take Greece. Not only did that country invent democracy and give us the word "economics," but it has a tax code that does not tax domestic dividends at the individual level at all. That is the sensible tax structure that President Bush has proposed for the United States.

Other countries, such as Australia, Finland, Mexico, New Zealand and Norway fully offset the double taxation of dividends with an individual tax credit. So relief from double taxation like the president has proposed is not at all radical -- it would simply move the United States into the mainstream of tax systems. Indeed, after a review of tax policies in the 30 industrial countries of the Organization for Economic Cooperation and Development, I find that 27 countries provide full or partial relief of dividend double taxation. Relief is usually provided through an individual tax credit or a reduced tax rate on dividends.

Countries offering their citizens dividend tax credits include Canada, France and the United Kingdom. Countries providing dividend tax rates that are lower than the ordinary rates on wages include Austria, Belgium, the Czech Republic, Denmark, Hungary, the Netherlands and Poland. Some countries, including Finland, Norway and Sweden, have "dual income tax systems" that impose high rates on wage income, but lower flat rates on all types of capital income, including dividends and capital gains. Yet another form of relief is an individual exclusion. Two countries, Germany and Luxembourg, offer a 50-percent dividend exclusion to individuals. That means that if a shareholder receives $1,000 in dividends, $500 would be tax-free.

Among the 30 OECD countries, only Ireland, Switzerland and the United States do not offer dividend tax relief. However, corporate income tax rates in Ireland and Switzerland are just 12.5 percent and 24.5 percent, respectively, with the result that dividends face a lower overall tax burden in those countries than in the United States.

Clearly, the United States is out of step with the pro-growth dividend tax policies of other nations. Foreign policymakers have figured out that high dividend tax rates damage the economy by creating numerous distortions.

First, high dividend taxes add to the income tax code's general bias against savings and investment. Second, high dividend taxes cause corporations to rely too much on debt rather than equity financing. Highly indebted firms are more vulnerable to bankruptcy in economic downturns. Third, high dividend taxes reduce the incentive to pay out dividends in favor of retained earnings. That may cause corporate executives to invest in wasteful or unprofitable projects. Also, it is harder for investors to accurately value firms when they do not receive a regular cash dividend stream. Fourth, high and uneven tax rates on dividends and other types of capital income increase the wasteful efforts of financial engineers to design ways of avoiding taxes.

President Bush's tax proposal would go a long way toward fixing these serious problems in the tax code. Reform is long overdue because the United States overtaxes dividends compared to other countries. U.S. shareholders deserve much better treatment, and it is now up to the U.S. Congress to deliver it.


Chris Edwards is director of fiscal policy at the Cato Institute.