Who Really Benefits from Dividend Tax Relief?
by Norbert J. Michel
Center for Data Analysis Report #03-02
heritage.org
January 7, 2003 | |
With major tax reform once again heading the list of legislative priorities, many analysts are hoping that the 108th Congress will make tax law far less a factor in economic decisions than it is today. Making the tax code more economically neutral is particularly desirable when it comes to the tax treatment of dividends paid on investments, since millions of Americans, including many who earn less than $100,000 a year, earn dividend income.
Corporations pay dividends to investors out of after-tax profits, yet these dollars are then subject to another tax: the personal income tax paid by the individuals who receive them. This multiple taxation of dividends discourages investors from finding equity investments that pay a steady stream of income and encourages corporations to retain profits and seek debt financing solely for tax purposes rather than financing their operations with equity.[1] Indeed, these effects may well mean that the tax treatment of dividends is contributing to some of the economy’s worst problems, underscoring the hope that Congress will make the tax treatment of dividends more economically neutral.
This economic neutrality could be achieved in a number of ways.[2] For example, corporations could be allowed to deduct dividend payments from their taxes (just as they do with interest payments), or individual investors could be given tax credits on their personal tax returns using the “imputation credit” method. Other countries that have eliminated or reduced the multiple layers of taxation on dividends include Australia, France, Italy, Japan, Germany, Canada, and Great Britain.[3] All of the possible methods have the same goal: reducing the multiple layers of taxation on corporate income.
Consider this example. Assuming a marginal tax rate of 35 percent, for every $100 of pre-tax corporate profits, the federal government initially will take $35. It then will tax the remaining funds again, depending on how much of the $65 the firm decides to pay out as dividends to investors. If the entire $65 were distributed directly to individuals as dividends, the full amount would be taxed as ordinary income to individual investors who receive the dividends.[4] An individual in the 27 percent marginal tax bracket would pay approximately $18 in taxes upon receiving the dividend, leaving only $47 of the original $100 in corporate profits actually paid out to investors. In other words, for every $100 in pre-tax profits, the federal government will take approximately $53—more than half of every dollar earned.
Contrary to common perceptions, such double taxation of dividends affects nearly all Americans, not just a select few. As this report will show, most Americans stand to gain from the elimination of the double tax on dividend dollars. The reasons:
Corporations exist in conjunction with people. The corporation exists only as a legal entity owned and operated by individuals. By definition, all corporate taxes must affect the income available to the owners and workers of the corporation. Since people, not “corporations,” pay taxes, taxing income at both the corporate and personal level results in taxing the same income twice.
The double taxation of dividend dollars affects all investments. All investment vehicles compete for investors’ dollars; therefore, any noticeable change in one investment’s rate of return must affect the others’ relative rate of return.[5] Furthermore, all true dividends are subject to this double taxation.
Millions of families would benefit from dividend tax relief whether or not they directly receive dividends. By the end of 2000, about 42 million workers in the United States with a median annual salary of less than $60,000 owned a 401(k) plan. Similarly, at the start of 2002, some 40 percent of U.S. households with a median annual household income of $55,000 owned an individual retirement account (IRA). Since the same investments held in retirement accounts are also held in non-retirement forms, these families with private retirement accounts would also share in the benefits of dividend tax relief.
Many moderate-income workers receive dividends. In 1998, 70 percent of all taxpayers directly receiving dividends earned less than $55,000 in wages and salary. In the same year, 90 percent of all single taxpayers directly receiving dividends earned less than $53,000 in wage and salary income, and 70 percent of all married couples directly receiving dividends earned less than $76,000 in wage and salary income in 1998. Even after considering issues regarding how the Internal Revenue Service (IRS) reports some non-dividend income as “dividends,” it is unlikely that only the top one or two income groups would benefit from dividend tax relief.
dispelling Myths about dividend income
A common misconception is that dividend tax relief would benefit only a select few Americans. Part of the reason has to do with how the IRS classifies “dividends.”
A recent article by William Gale of the Tax Policy Center, for example, notes that “just under half—46 percent (93/201)—of dividends paid out of the corporate sector were subject to double taxation in 2000.”[6] The ratio mentioned in these calculations refers to two measures of dividends: the IRS measure of dividends ($93 billion) and the National Income and Product Accounts (NIPA) definition of dividends ($201 billion). Interest received from mutual funds is reported as dividend income on the IRS 1040 form, and a portion of NIPA dividends includes distributions from S corporations.[7] Neither item is subject to double taxation, but neither item represents dividends.
Regardless of how various types of earned income are classified by the IRS, all real dividends are subject to double taxation. Even when dividend-paying equities are held in retirement accounts, they are subject eventually to double taxation.
It can also be argued that the harmful effects of the double taxation of dividends are not simply confined to the real dividends declared on individual tax returns.[8] In fact, the effects of the tax structure are not necessarily confined solely to equity markets. Individuals choose from an array of investment choices based on the real after-tax rate of return they expect. Since all the various investment vehicles are competing for investors’ dollars, any material change in one investment’s return has to affect the relative return of others. Therefore, the double taxation of dividends indirectly affects the returns of all investments—even those in tax-deferred retirement accounts.
In 2001, nearly $2.4 trillion in retirement plan assets were invested in mutual funds, with roughly a 50/50 split between IRAs and employer-sponsored retirement plans such as 401(k) plans.[9] Nearly $1.5 trillion of these assets were held in domestic equities. While these equities were held in tax-deferred retirement accounts through mutual funds, at the same time, they were also being held by non–mutual fund and non–retirement account investors.
Thus, any given equity investment is likely to be held individually, in mutual funds, and in retirement accounts simultaneously. Since dividend tax relief means that firms are more likely to increase their dividend payments, the benefit of this type of tax relief will also accrue to individuals holding equities in retirement accounts even though the benefit will not immediately show up on their tax returns.[10]
Exactly on which tax returns these benefits will appear is another interesting question. By the end of 2000, roughly 42 million U.S. workers with a median annual salary of less than $60,000 participated in a 401(k) plan.[11] Similarly, approximately 42 million U.S. households with a median annual household income of $55,000 (40 percent) owned some type of IRA.[12] Data also show that, as of 2002, nearly 53 million U.S. households (just under 50 percent) held some form of equities and about 84 million individuals owned some form of equities.[13] Given that these equities exist in both retirement and non-retirement accounts, and that the double taxation of dividends affects the relative returns of all investments, it should be clear that eliminating the double taxation of dividends will not benefit only a select few, but rather millions of Americans.
Nonetheless, opponents of dividend tax relief are likely to point to statistics that indicate most taxpayers do not receive dividends and to label dividend tax relief—much like capital gains tax relief—a boon to “the rich.”[14] However, the IRS’s own data from its 1998 Public Use Tax File from the Statistics of Income Division (SOI) show why this sort of “evidence” is misleading.[15]
a look at who receives dividends
Statistics from the same IRS data set—the SOI 1998 Public Use Tax File—can be presented in several different ways to lead to different observations. Despite a few shortcomings involved in using these data for this purpose,[16] doing so clearly shows that middle-income America would benefit from dividend tax relief.
Tables 1 through 6 show the distribution of dividends for all taxpayers in 1998. Tables 7 through 12 show the distribution of dividends among taxpayers who received dividend income in 1998 and thus would be directly affected by ending the multiple taxation of dividends.
Table 1 summarizes statistics for all individuals in the 1998 SOI file regardless of filing status, age, or whether they received dividends. It shows that many taxpayers do not receive dividends directly. In fact, even when these taxpayers are examined together (Panel A), or as single filers (Panel B), or as married filers (Panel C), the median taxpayer has dividends of $0—meaning that 50 percent of all taxpayers report no dividend income.
The percentiles for these groups of taxpayers, shown in Table 2, show that out of roughly 124 million taxpayers, 70 percent do not receive dividends. Only when examined separately as married filers (Panel C) does the 70th percentile include any dividend income; 70 percent of both combined filers (Panel A) and single filers (Panel B), with an after-tax income of just under $43,000 and $25,000, respectively, report $0 in dividends.[17]
Moreover, based on these data, only married filers (Panel C) report much investment income at all. The 50th percentile for single filers includes $0 interest, and the 80th percentile includes $0 capital gains. Similarly, the 40th percentile for combined filers includes $0 interest, and the 80th percentile shows $0 capital gains.
When these groups are partitioned by age, Table 3 shows that the 50th percentile for dividend income remains at $0 for all types of filers in the pre-retirement age group. However, dividend income does register at the 50th percentile for all three groups of filers in the post-retirement age group (see Table 5).
In the post-retirement group, however, the 80th percentile taxpayer reports dividend income in all three filing groups. Table 6 shows that single filers at the 80th percentile, with an after-tax income of $34,740, report dividend income over $6,000; married filers, with after-tax income of about $64,000, have dividend income over $4,000.
Even given this higher proportion of dividend-receiving taxpayers in the post-retirement group, using only the data in Table 1 through Table 6, it is still rather easy to support a claim that only the wealthy will benefit from dividend tax relief. One could argue, for example, that since 80 percent of all taxpayers receive less than $46 in dividends (Table 2, Panel A), dividend tax relief benefits only the upper 20 percent of taxpayers.
A problem with this logic is that the data in these six tables do not distinguish between those taxpayers who receive dividends and those who do not. Therefore, these data do not accurately describe the characteristics of taxpayers who receive dividend income. For this reason, Tables 7 through 12 present summary statistics and percentiles using the same groups of taxpayers but examining the data only for taxpayers with dividend income.
The statistics reported in Tables 7 through 12 paint a very different picture. An examination of all dividend-receiving taxpayers (Table 7, Panel A) shows that their median after-tax income is just under $44,000, with dividend income of $478, interest of $435, and capital gains of $220.[18]
As seen on Panel A of Table 8, the 70th percentile taxpayer has an after-tax income of about $68,000 and dividend income of $1,650. These figures show that 70 percent of all taxpayers who received dividends in 1998 earned less than $68,000 in after-tax income.[19] Just as telling is the fact that the median wage and salary income for this 70th percentile taxpayer is just over $55,000 in 1998.
Similarly, single taxpayers receiving dividends have a median after-tax income of $18,718, dividend income of $515, interest of $317, and capital gains of $338 (Table 7, Panel B). Even single taxpayers at the 90th percentile, reporting dividend income of over $7,300 (Table 8, Panel B), have an after-tax income of just over $63,000 and wage and salary income of about $53,000.
Panel C of Table 7 shows that the median reported after-tax income of married taxpayers receiving dividends was about $64,300, with a median dividend income of $481. Married taxpayers at the 70th percentile (Table 8, Panel C) with an after-tax income of $89,339 report dividend income of $1,671 and wage and salary income of just over $76,000.
Further partitioning the data on the dividend-receiving taxpayers into pre- and post-retirement ages produces similar results. As Table 9 shows, the median pre-retirement age single filers (Panel B), married filers (Panel C), and combined single and married filers (Panel A) all report about $300 in dividends. These results are quite different from those on Table 3, where all pre-retirement age taxpayers—even those not receiving dividends—were found to have $0 in dividends at the median.
When only post-retirement age, dividend-receiving taxpayers are considered, the median taxpayers’ (single, married, and combined) dividend income is $2,406, with an after-tax income of $35,544 (Table 11, Panel A). The median single taxpayer in this group (Panel B) has a lower after-tax income of $21,844 and a higher dividend income of $3,184. Panel C shows that the median married taxpayer in this group has an after-tax income of $44,921 and a dividend income of just under $2,000.
The three panels in Table 10 and Table 12 list the percentiles for the three categories of filers in the pre-retirement and post-retirement age groups, respectively. The 80th percentile taxpayer in the pre-retirement age group (Table 10, Panel A) has an after-tax income of about $98,000 and dividend income of $1,643. When this is compared with the 80th percentile taxpayer in the post-retirement age group (Table 12, Panel A), who has after-tax income of just under $60,000 and dividend income of about $10,000, it appears that dividends make up a larger percentage of retired people’s income. Similar results for both single and married taxpayers in the post-retirement age group (Table 12, Panels B and C) confirm this finding.
Thus, many Americans who invest in the business of America are not “rich,” but rather single, married, and retired Americans who make under $100,000 per year. All of these Americans would benefit from dividend tax relief.
conclusion
The double taxation of dividends in the U.S. tax code distorts economic activity because it encourages the retention of corporate profits and debt financing and discourages dividend payments and equity financing, solely for tax purposes.
Eliminating the double taxation of dividends would be a positive step toward tax neutrality. Millions of families would benefit from dividend tax relief, including the many moderate-income workers who receive dividends. As of 2000, more than 42 million American workers owned a 401(k) plan, and nearly 40 percent of all U.S. households owned an IRA. Data show that, as of 2002, nearly 53 million U.S. households (just under 50 percent) and about 84 million individuals owned some form of equities. Additionally, in 1998, 70 percent of all taxpayers receiving dividends earned less than $55,000 in wages and salary.
All true dividends are subject to double taxation. Since all investments compete for investors’ dollars, removing the 35 percent layer of corporate dividend taxes would affect other investments as well. Even the fact that many Americans hold equities in tax-deferred accounts will not, in the long run, diminish the impact of eliminating the double taxation of dividends. Dividend tax relief may be criticized as providing a tax break for “the wealthy,” but the IRS’s own data clearly suggest otherwise.
Norbert J. Michel is a Policy Analyst in the Center for Data Analysis at The Heritage Foundation.
Appendix
Methodology
One issue surrounding the use of tax return data is the definition of taxpayers’ income. For example, individual returns vary from reporting only wage and salary income to reporting up to 15 different types of income.[20] For statistics derived from the Internal Revenue Service’s data in its 1998 Public Use Tax File from the Statistics of Income Division (SOI), the author has used a broad definition of income that includes virtually all non-investment income.[21] The measure is calculated for each observation in the SOI 1998 Public Use Tax File and includes the following types of income:
Wages, salaries, tips, etc., from employees’ W-2 forms;
Alimony received;
Business income or loss;
Other gains or losses (sales of business property);
Total taxable IRA distributions;
Total taxable pensions and annuities;
Rental real estate, royalties, partnerships, S corporations, trusts, etc.;
Farm income;
Unemployment compensation; and
Social Security benefits.
Aside from those already mentioned, using the data in the SOI Public Use Tax File for this purpose presents two major shortcomings. It should be noted that the amount reported as “wages, salaries, tips, etc.” on the W-2 form does not include payroll taxes or any wages and salary contributed to employer-sponsored tax-advantaged savings plans: cafeteria plans, 401(k) plans, etc. Also, “dividend income” on the IRS form 1040 does include cash distributions that are actually interest payments, not dividends.[22]
Next, the author combined the total tax owed or refunded with the above types of income to create a variable for “after-tax income.” The after-tax income variable basically includes all income other than that earned from investments. In other words, it excludes income from dividends, capital gains, and interest. Therefore, the calculated after-tax income serves as a broad measure of taxpayers’ “permanent” income.[23]
Summary statistics (mean, median, and standard deviation) and percentiles are calculated for all returns as well as for those returns reporting dividend income. As reported above, when all returns in the 1998 SOI file are considered, more than half of all taxpayers do not report dividend income. Therefore, focusing on all returns alone does not provide a clear picture of the income (and other characteristics) of those individuals reporting dividend income.
Consequently, the author examined filers in every filing status (single, married filing jointly, married filing separately, head of household, or widower) for all ages in two separate categories— those receiving dividends and those not receiving dividends. Additionally, the data in both categories are partitioned based on filing status for both pre-retirement age and post—retirement age taxpayers.
In regard to filing status, the author first combined all filers and then examined single and married filers separately (married filing separately and married filing jointly were combined as married filers). Finally, while it is not a perfect classification, all returns including Social Security benefits are categorized as “post-retirement age,” and all returns not reporting such benefits are categorized as “pre-retirement age.” |
