Even Senate Democrats may keep dividend taxes low

Voting this week to let tax cuts expire for the wealthy, Democratic senators are likely to make a curious exception for taxes on dividends.  

Senate Democrats, who will vote this week to allow most of the 2001/2003 tax cuts to expire for high-income households, are likely to make an exception for capital gains and dividends.

Under their proposal even top bracket taxpayers would pay a maximum rate on this investment income of 20 percent in 2013 (plus an additional 3.8 percent under the tax provisions of the 2010 health law). That would be far below the rate on ordinary income, which Democrats would restore to 39.6 percent.

Their choice is interesting, especially since the evidence is mixed at best on whether the big tax cuts on investment income in 2003 did much to help the economy.  Indeed, economists still don’t agree on how much the 2003 dividend tax cut boosted payouts to shareholders, and whether it was good for economic growth or not.

Some of the nation’s best tax economists have been peering at the data for a decade and the most they agree on is that firms did increase dividends after the tax cut passed. But did the tax cut cause the change? That, it seems, is the matter of more than a little debate. University of Illinois economist Dhammika Dharmapala has a nice summary of the research in the book “Tax Policy Lessons from the 2000s” edited by Alan Viard (AEI Press, 2009)

To understand what’s going on, keep a couple of things in mind. First, remember that companies can choose what to do with their profits. They can distribute them directly to shareholders through a dividend, or indirectly by buying back their own stock( which makes remaining shares more valuable).

They also can retain earnings, eventually reinvesting them in new equipment, hiring new workers, or buying other companies.  In that event, those returns might eventually be distributed to shareholders as future dividends or capital gains.

Thus, one key question is whether the cut in dividend taxes increased the total amount companies distributed to their shareholders or just changed the way they did it by, for instance, increasing dividends but reducing share repurchases.

In addition, about half of all corporate dividends are paid to investors that don’t pay tax—pensions, non-profits, foreign entities, and the like. Changes in the dividend tax rate don’t affect their tax bills. However, they still might care if higher dividend payouts boost the share prices of their investments.

Sorting it out isn’t easy, especially since there was so much else going on in the early and mid-2000s. For instance, the post dot-bomb corporate governance scandals drove many firms to pay dividends regardless of the tax rate. Rising stock prices from 2003 to 2007 may have discouraged share repurchases.

The weight of the evidence seems to be that companies did boost dividends after the 2003 tax cuts and those increases were concentrated in firms where managers owned a lot of stock. Make of that what you will.

(ADDENDUM: A new paper by Federal Reserve Board economist Jesse Edgerton  throws more cold water on the claim that the dividend tax cut generated more payouts. Among other things, he finds that the increase in dividends corresponded to a comparable rise in corporate profits).

But what did this mean for the overall cost of capital, which is the real question? On that, even 10 years after the 2003 tax cut, we simply don’t know. As Dharmapala notes, research shows that while the value of firms with high dividend yields rose, the value of non-dividend paying firms rose even more.

Given all that uncertainty, Senate Democrats are making a curious choice. They seem to want to continue a dividend tax cut, despite the lack of evidence that it did much to help the economy over the past decade.