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Jumping on the tax-cut train? Not so fast?

As I See It

I’m usually wildly enthusiastic about any proposed tax cut. I think government is too big, and the only way to reduce the size of government is to cut its allowance.

Tax cuts are designed to help the poor, stimulate the economy or encourage some behavior by taxpayers.

Regardless of motive, I’m for cutting them — most of the time.

The current Bush tax cut proposal is an interesting little number. Though the package touches several areas of the tax law, I want to focus on the provision making dividends tax-free to investors.

Let’s start at the beginning. When any business, other than a corporation, earns a profit income taxes are due on that profit. The ultimate disposition of the profit remaining after the taxes are paid is of no interest to the IRS. With corporations it’s a different story.

Corporations pay income tax on their profits. When the after-tax profit is distributed to the shareholders, it is taxed again as dividend income. Thus, corporate income is subject to double income taxation.

The result is that corporations are encouraged to retain their after-tax profits in the company in the hope of increasing stock value, which will ultimately be taxed at the lower capital gains rates when the stockholders sell their stock.

The Bush tax cut plan would eliminate the second income tax by making the dividends tax-free to shareholders. In addition to the fairness issue, the administration believes economic stimulus would result from cutting investor taxes. Administration officials also believe that this change would encourage corporations to pay out more of their earnings in dividends, which would further stimulate the economy.

Historically, companies have paid out an average of 57% of their after-tax profits as dividends. In the mad rush to grow companies during the last decade, that percentage has dropped to just 33%. The “new economy” worshiped stock price appreciation more than cash dividend payout.

The beneficiaries of the Bush tax cut proposal will be an even smaller group of taxpayers than it appears on the surface. Most individual stock investors own their stocks inside retirement plans and pay no tax on the plan income until it’s withdrawn at retirement. In fact, as of the end of 2001, 64% of household’s stock investments were held in variable annuities, IRAs, 401(k) and other tax-sheltered arrangements. Assuming no other changes in the retirement plan arena, these folks will get no benefit from changing the taxation of dividends since everything they draw from their retirement account will be taxable when withdrawn. Only the very small group of wealthy individuals who own stock outright will benefit from the Bush plan.

I believe there is a better way to accomplish the goal. Corporations finance growth in one of two ways: either by raising equity capital in the stock market or by borrowing the funds from banks or other lenders. Since the interest paid on debt is tax deductible, there is a tax incentive to borrow money rather than increase equity capital. Assuming that lenders and investors demand about the same payment in either interest or dividends, it is cheaper to pay tax-deductible interest.

If corporations were allowed a tax deduction for the dividends they pay the tax incentive for using borrowed money as capital would be eliminated. Debt and equity capital would then be on equal footing. Investors would pay income tax on the dividends they receive if they own stock or the interest they get if they own bonds or other debt instruments. Double-taxation would be eliminated and debt and equity investors would be on a level playing field.

Any tax cut proposal is going to be lambasted by the Democrats as favoring those hated wealthy Americans. Well, tax cuts will, and should, favor the wealthy since they are the ones paying the lion’s share of taxes. Perhaps to make my alternative more palatable to the masses it should be coupled with eliminating some of the corporate tax scams that have come to light over the last few years, such as re-incorporation off-shore to avoid U.S. taxes altogether.

How did corporate dividends ever get into the double-taxation debacle in the first place? As a young, aspiring accountant many years ago, I asked a seasoned tax accountant that very question. His response pretty much summed it up then and is probably equally valid now — corporations don’t vote.

Thought for the Moment — I don’t know the key to success, but the key to failure is trying to please everybody else.

— actor Bill Cosby

Joe D. Jones, CPA, is publisher of the Mississippi Business Journal. Contact him at cpajones@msbusiness.com.


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