Last week, I expressed my wish that the US would move from income taxes to consumption taxes and wondered if the move to eliminate the dividend tax was a step in that direction. As part of that, I repeated the common refrain that one of the problems with eliminating the dividend tax is that people who own companies can easily use this change to pay absolutely nothing in federal income taxes. I linked to Warren Buffet who has been one of the most vocal critics of eliminating the dividend tax.
I received an email from Jack, who blogs at the Periphery of Known Space. We started discussing the affect the new tax legislation will have on dividends. As part of our discussion, I asked about his background.
Jack enlisted in the Army in 1989. He was a Calvary Scout and served in Germany and the States. He was honorably discharged in 1992, and enrolled in a Californian trade school for automated accounting/full-charge bookkeeping. In 1996, he went to college in New York and starting interning in 1998. He is now a Senior Tax Consultant at one of the Big 4 accounting firms. (I am getting old, I remember when people talked about the Big 8 accounting firms). As you might expect, Jack has been closely following the new taxation laws.
Keep Jack's expertise in mind as you read his words:
Warren Buffet is wrong. Buried towards the end of the Bloomberg article is this quote from Steve Forbes, "..and part of it is a misunderstanding that the dividend income shouldn't be taxed twice." Warren knows a lot about amassing wealth, but I guess he doesn't know squat about taxes or he thinks everyone else is a fool.
The $3b that Warren's company would hypothetically issue in dividends is what is left over of the original $5b after the federal and state governments take their 'fair' share. So the government already has taken 2/5 of the income that the company has earned. This isn't itself a problem; the government needs to be funded. The problem is that when the company pays the dividend, the proceeds will be taxed again, hence double taxation, at the same statutory rate of 40% (+or-). Therefore, of the $3b, $1.2b is paid in taxes leaving $1.8b for the shareholders to do as they wish. The effective tax rate on the original $5b is now 64%.
This is an excellent point. Those that oppose the elimination of the dividend tax have only pointed out that owners would pay no personal income tax if they elected to pay themselves via dividends. However, they completely ignore the fact that the company already pays ~40% in Federal and State corporate income taxes. I confess that I have been inadvertently among those looking at the smaller picture and I thank Jack for correcting me.
Since most of us will never own a company worth billions, let me restate Jack's point with a simpler example. Assume you own a small firm. After years of effort, your company is starting to make a profit. After all expenses other than your own salary, your firm has a profit of $100,000. Assuming that the dividend tax is eliminated, let us look at two options.
Option A: You listened to Warren Buffet and decided not to pay yourself a salary. Instead you will pay yourself in dividends so you can avoid paying personal income taxes. So your firm made a profit of $100,000 and has to pay $40,000 in state and federal corporate income taxes. That leaves you with $60,000 and you pay no personal income tax on this.
Option B: You ignore Warren Buffet and pay yourself a salary of $100,000. After paying your salary, your firm breaks even (no profit, no loss) and pays no corporate income tax. You earn $100,000 and pay $40,000 in state and federal personal income taxes. This leaves you with $60,000.
Either way, you pay taxes. For the sake of simplicity, I did not try to minimize taxation by considering personal deductions, combinations of salary and dividends, etc., so the actual amount of taxes would vary. The point is that Warren Buffet and I were wrong. Eliminating the dividend tax does not give the rich a free ride. It simply would eliminate double-taxation.
However, the media accounts are doubly wrong. The new tax laws do not eliminate the dividend tax. Instead, the rate has been lowered to 15%. According to Jack:
The new law will tax dividends at 15%. Therefore the shareholders will effectively receive $2.55b, giving the dividends and effective rate of 49%. This reduction still wouldn't allow taxpayers to amass wealth without paying taxes as Warren suggests. Adding the anti-abuse provisions that were included in the previous and current tax cuts, the federal and state governments will still be able to sleep easy knowing that the 'richest' will not "pay absolutely nothing" in income taxes.
Jack also shared some of the background of the new tax laws:
When the two tax bills were working their way through the House and Senate, the House favored 0% tax on dividends, while the Senate version favored the taxpayer to exclude the first $500 of dividend income from their ordinary income, and the remainder would be tax at 10% in 2003 and 20% in 2004. The version that passed applied a 15% capital gains rate, or 5% capital gains rate for taxpayers in the 10%-15% brackets, on all dividend income.
This does not surprise me. Recently the House has had the admirable view that if you are going to do something, do it right. Unfortunately, the Senate seems to prefer half-measures and the resulting compromise bills are usually weaker than what the House wanted. Some of this difference may be due to the larger Republican Majority in the House vs. the Senate. However, I believe most of the difference is due to the term length differences between the House and Senate. Congressmen serve two-year terms while Senators serve six-year terms. This difference may be the reason why the Senate has tradionally been more conservative than the House, no matter which party holds the majority.
One of the best things about blogging is that it allows one's assumptions to be challenged. I am fortunate that my readers send me thoughtful responses to my discussions. I hope that my readers learn from my posts. I certainly learn from their responses.