The Bush tax cuts, more specifically the debate over extinction or extension, have come under serious debate. In fact, it is looking more like the issue has been catapulted in to the status of a key political issue for the mid-term elections. At the beginning of 2010, and some would argue quite frankly at the beginning of the Obama Administration, it was just assumed that tax rates would be going up under this new administration. The liberal pundits try to spin some silly case that tax rates have or will actually fall – but this argument is thin at best and down right fraudulent and morally incomprehensible at worst. Opponents of the Obama administration correctly point out that at the very least the Bush tax cuts are set to expire, and unless action is taken by Congress, tax rates will be going up by this virtuous fact alone. Needless to say, I don’t find the argument that tax rates are falling for most Americans remotely compelling. So, without getting into the more insidious and confusing tax policy issues such as healthcare or anything else…it seems fairly clear that tax rates are set to rise due to the expiration of the Bush tax cuts. One must ask, should the Bush tax cuts be allowed to expire?
Oddly enough I don’t find the argument by the proponents of the Bush tax cuts very compelling either. The notion that capital gains taxes and dividend taxes will directly influence the economy via capital investment/employment is a pretty big stretch. Perhaps one could momentarily entertain the thought of some sort of trickle down theory of real investment by retaining an extra 15% of dividends paid out by his/her companies in they have invested – but that is really thin at best. I suppose capital gains might have some trickle down impact if an entrepreneur decides to sell his/her enterprise and subsequently create a new business. If they are able to retain some extra capital via a lower capital gains tax rate maybe this could influence the real economy. Although one may wonder how many business owners are anxious to build a new enterprise (a task that is daunting and challenging at every turn) immediately after selling one they have worked hard to build over the course of a 20-40 year career?
I just can’t wrap my head around the notion that straight up capital gains and dividend taxes are that important to the real economy. Don’t get me wrong…I do not support the government spending this money for me. I just think this argument is ineffective.
Nonetheless I am in favor of extending the Bush tax cuts. Or actually what I would prefer is that the Bush tax cuts be modified and then extended–perhaps indefinitely. I believe the dividend tax rate should be cut to zero. That’s right ZERO, zilch, nada. Here’s why…
It is entirely unfair to tax something twice. Corporate earnings were already taxed and thus to tax earnings again is a morally repugnant effort of politicians to fund politically motivated spending and violates a sense of fair play not to mention the fact it increases the paperwork burden inherent in tax filing.
Taxing dividends increases the cost of capital of equity financing while simultaneously incentivizing the use of debt financing via interest payment deductions.
The tax penalty prompts companies to retain earnings rather than paying profits to investors.
The first point is philosophical in nature and I just happen to fall on the line in the sand that believes the tax code in the United States is a terrible joke for a developed nation. Our own politicians can’t even file their taxes properly, as Obama found out with his appointees, thus simplicity should be paramount. Anything that simplifies the tax code should be enacted. Moreover, some readers will probably disagree with me on the role of government spending and that is a fine disagreement to have. Thus, reason 1, in my mind, is sufficient enough to reduce the dividend tax rate to zero on a permanent basis. However, there are many that won’t be convinced by this point alone.
Secondly, in my mind it is hard to refute the claim that the cost of capital is influenced by tax rate differentials between debt and equity financing. If this seems meaningless in your mind, what do you think CFOs do for a living? They are responsible for financial reporting, capital investment decisions, and the management of the company’s present financial condition. These people decide how much debt vs. equity financing is appropriate for the company, and assuming they are remotely concerned with the explicit goal of any for profit company: maximize shareholder value…their mission implies obtaining a low cost of capital.
Given that we are in a balance sheet recession brought on by excessive debt accumulation, perhaps it might be a good idea to take initiatives to remove penalties on the use of equity financing or at least reduce the penalties by cutting dividend taxes to zero. Okay, so some of you are still not convinced but hopefully you will be soon.
My third argument is the biggest and best in my opinion. I think both parties have been getting the tax cuts wrong and I believe point number three addresses this issue more appropriately. The tax penalty on dividends prompts companies to retain cash rather than payout profits to shareholders. Apple (NASDAQ:AAPL) is said to hold approximately $45 billion dollars in cash on its balance sheet. Pfizer (NYSE:PFE) holds some $17.9 billion of short term securities while Johnson & Johnson (NYSE:JNJ) holds roughly $18.8 billion in cash and short term investments. Think of all the unnecessary cash sitting on the balance sheet of corporate America collecting a pitiful interest rate. There has to be at least a trillion dollars of unproductive cash just sitting there on corporate balance sheets. One source from Bloomberg claimed S&P 500 cash balances were at $1.18 trillion dollars - and that was in Feb 2010.
So I want to ask you, if there were no dividend taxes, what sort of impact would a MAJOR cash reduction by corporate America have on the real economy? In my mind this would have an impact of mythic proportions – especially if the benchmark of comparison is any politically motivated government stimulus program. Think about that...several hundred billion dollars of cold hard cash flowing through pension funds, mutual funds, 401K and IRA accounts, hedge funds, wealthy individuals, and plain ole’ ordinary folks setting money aside who hold stocks.
It’s not like corporate America is expanding capital investment programs. In fact capital budgets, in aggregate, are probably going the other way which is, to a large extent, why so many firms have cut employment. Perhaps dolling out that idle cash would actually spur some demand for product. Perhaps a big fat tax free dividend check by corporate America would get the M’s going?
My third argument seems overwhelmingly compelling to me, although I am naturally bias. In fact, in lieu of capital expenditure reductions, I cannot think of any particular reason why this would be a bad idea. Sure, simply reducing the dividend tax rate to zero doesn’t mandate that corporate America issue one big fat dividend check…but it sure would make stock holders more likely to say “s*&% or get off the pot.” And any associated consumption and/or investment boom that could potentially be spurred from this policy action might just turn out to make quantitative easing look like an ice cube in front of the Titanic in terms of its effect on the real economy.
Thank you for reading.