A Bad Time for Bad Medicine

Smoke arises from a cauldron as the Bush Administration cooks up a cure for the economy. It is a potion of corporate dividend tax cuts, and it looks like another media score for the Mayberry Machiavellis. The magic ingredient, called sound-bite-of-Newt, is the incantation of double taxation. It is as sexy a curse as "death tax." It is designed to charm the public, but it will neither stimulate the economy and nor raise economic efficiency.

The double taxation incantation is hot air. Working people are double taxed more harshly as they pay income taxes on their wages, and then pay sales taxes on clothes, household goods, gasoline and beer. They also pay tax-like license and registration fees to fish, hunt and drive their cars. If they do not itemize, they are triple taxed from state and local income taxes. Rich people pay these too, but it is a much smaller percentage of their income.

Leave aside, for the sake of brevity, the fact that most of the benefits will go to the super rich in the top 1%. If the public thinks the wealthy deserve the most help, then they will get it. The debate over fairness is pretty clear, but the claims about stimulus and efficiency raise a lot of smoke.

The notion for the potion is that taxing dividends creates a potentially large bias against holding stocks, this is known as a distortion amongst economists, and removing this bias will hike stock prices, increase investment and spur the economy.

Free from the smoke, a clear-eyed look at the tax cut shows its fallacies. Individuals currently pay income taxes on capital income irrespective of whether they receive it in the form of interest on corporate bonds or dividends from corporate stocks. There is no distortion there, and it conforms to the principle of the Cato Institute's Niskanen that similar things and activities be taxed equally. Cutting the personal income tax rate on dividends will create a bias towards holding stocks instead of bonds, mortgage securities, CDs and other interest paying assets. In order to equalize after-tax returns, corporations and home owners will have to pay relatively higher interest rates to borrow while the price of stocks will rise to give windfall gains to existing holders of shares. Only the book of spells knows how this will boost the economy.

What about corporations that pay little or no dividends? These are the fast growing corporations, new start-ups or corporations that are in trouble. Fast growing firms plough-back their earnings into new investment instead of distributing earnings as dividends. New start-ups, the source for so much new investment in the past economic expansion, do not pay out dividends because they are either reinvesting their earnings or are not yet operating at a profit. Troubled companies do not pay dividends because they cannot. These firms, and their investors, will see no benefit from this tax cut. A darker fear is that it will force some firms to curtail the reinvestment of their earnings in order to pay out dividends to satisfy investors' yearnings for low-tax income.

What kind of corporations pay the most dividends? They are the big, established "mature" firms. They may grow but not at the rapid pace of growth stocks. When they invest, these big boys use retained earnings or issue bonds; they rarely raise new capital by issuing stock. A dividend tax cut might raise the price of their stock but it will just amount to a windfall to their existing shareholders.

Cutting the tax rate on corporate dividends will not provide a direct incentive to increase investment, employment or output. Thus it will not stimulate the economy. The tax cut will only serve to boost the after-tax income of stock investors, and it will benefit the big investors the most. They may spend more as a result of the tax cut, but any other effect on consumption and demand will be unlikely. Over the long-run, the rate cut will not improve efficiency by removing a costly investment bias, but it might well create a new one that will discourage investment by the most dynamic corporations in the economy.

The corporate dividend tax cut is being pushed by Bush as a solution for a problem that it will not fix. If a corporate executive or stock broker made claims like that about a new product or a new security, they would likely be found liable in court for securities fraud.

Randall Dodd, an economist, directs the Washington, D.C. based Financial Policy Forum. He can be reached at 202-533-2588, rdodd@financialpolicy.org or www.financialpolicy.org