The Bush plan gives the overwhelming share of its benefits to households at the very upper end of the income ladder. According to estimates prepared by the Urban-Brookings Tax Policy Center, nearly 45 percent of the tax cut for 2003 would go to households in the top 5 percent of income - those earning more than $134,000 per year - while only 22 percent would go to households in the bottom 80 percent of income - those earning less than $38,000 per year.
Despite the fact that more than 50 percent of Americans now have a stake in the stock market, the direct ownership of shares remains concentrated among the very wealthy. Most investors own mutual funds in tax-deferred retirement accounts, which will be unaffected by the elimination of the tax on dividends.
To counter charges that the plan is unfair, the Bush Administration argues that those who pay the most tax should get the largest tax cut. Furthermore, the administration claims that the plan will create conditions for economic recovery and job growth, spreading benefits to all segments of society. The president also has described his plan to eliminate dividend taxation as a sensible tax reform built on the principle that income should not be taxed twice.
Leaving aside questions of "fairness" and the salvos of "class warfare," will the plan actually stimulate spending by consumers? Will the plan spur investment by businesses, which has declined for over two years - the longest stretch in over half a century? And does the plan truly reflect good tax policy?
Consumer spending is likely to be influenced only modestly by the Bush plan. The reason is that households with high incomes - who stand to receive the overwhelming share of the tax cut - already are spending as much as they desire and so are not likely to increase their spending. By contrast, those at the lower end of the income spectrum often are constrained below what they desire to spend and thus are likely to spend almost every dollar of a tax cut. But these lower and middle-income households will receive very little of the tax cut. Under the Bush plan the vast majority of benefits flow to households at the upper end who are far less likely to spend any tax cut and more likely to save it.
Eliminating the tax on dividends is unlikely to spur business investment spending. The administration claims the dividend tax cut will help boost the stock market, thereby creating greater incentive for businesses to invest. But countless studies over the past several decades have found overwhelming evidence that business investment responds very little to changes in the stock market. Rather, the consensus among economists is that the major determinant of business investment is internal cash flow, also known as undistributed profits or retained earnings. Indeed, if tax on dividends is eliminated, businesses might now face pressure from shareholders to pay out more dividends resulting in less cash for investment.
In terms of representing a sensible tax reform, the plan fails miserably. Eliminating the personal income tax on dividends will introduce a bias against bonds, money market accounts, and certificates of deposit because interest paid on these assets will be taxed while dividends on stocks are not. Many senior citizens who rely on interest earnings to support their retirement will now pay a penalty compared to recipients of dividends. The Bush plan also is fiendishly complex. To cite one example: It eliminates the personal income taxation of dividends only if a company pays corporate profits tax. Accordingly, an investor will not know for sure whether future dividend payments are tax exempt until after the company reports its profits and corporate taxes, adding a new kind of uncertainty to investment planning. This and other complexities will make compliance with the tax laws more difficult and time consuming.
As it now stands, the president's proposal will do little to help shore up the sagging rate of investment and will provide only a small short-term stimulus to the economy. As a tax reform, the proposal is poorly designed and represents a step backward to a more complex and less transparent system.
Robert Murphy is an associate professor in the Economics Department.
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