300% Hike in Dividend Tax Will Starve Economic Engine, AEI Scholars Say

Two AEI scholars warn the economy will soon be running out of the fuel driving investment if tax hike is enacted in 2013

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A ticking time bomb for stock investors employing a dividend strategy is an expected tripling of the dividend tax at the start of 2013 unless the president and Congress reverse course, which is considered highly unlikely in an election year.

At a time when short-term bonds are yielding a quarter of a percent, and frustrated savers have precious few high-yielding alternatives (excluding chancy Greek 1-year bonds that yield 1,000% but carry a high risk of default in a matter of days), many investors have chosen to earn income through dividends on stocks.

But two scholars at the American Enterprise Institute, a conservative think tank, are warning in an opinion article in Wednesday's Real Clear Markets that Washington is about to tax, and thereby make more scarce, the fuel that drives investment in the economy.

Alex Brill, who served as a tax policy advisor on President Barack Obama’s Fiscal Commission and Alan Viard, formerly a senior economist at the Dallas Fed, write that “higher dividend taxation will impede the investment that fuels long-run growth, depress stock prices, and weaken incentives for good corporate governance.”

The two AEI scholars note that the expiration of the 2003 tax cut at the end of this year will drive the top rate from 15% to 39.6%. But combined with the start of a new 3.8% tax on wealthy Americans to fund the administration’s health care law and other provisions phasing out deductions for high-income taxpayers, “the top all-in dividend tax rate will be 44.6%.”

While the tax rates on ordinary income and capital gains will see increases of nearly 25% and 60%, respectively, the dividend tax hike will rise by just under 300%, and this tax change will have the effect of penalizing investment, particularly stock-financed investment, the authors say.

Brill and Viard say that one effect of the tax increase will be an increase in corporate borrowing. Since the tax system imposes two levels of tax on stock issuance–a corporate tax and dividend tax–the removal of the tax break for individual stockholders will shift the pendulum back to greater debt issuance, where corporations can at least write off interest payments.

The hike in dividend taxes will also harm corporate governance. The authors say annual dividend payouts consistently totaled around $25 billion until the 2003 reduction in dividend taxation, after which payouts climbed to $33 billion. “Increased dividend payments make it harder for management to hide a company's true financial condition or divert corporate funds to their own pet projects. The president's dividend tax hike will undo the recent progress on this front,” write Brill and Viard.

The two AEI scholars say that ultimately reduced investment as a result of the tax hike will erode the capital stock, making workers less productive and ultimately holding down their wages.

Alan Viard, reached by AdvisorOne, adds that the dividend tax hike should also depress stock market performance. “Such a steep dividend tax hike would surely lower stock prices (relative to what they otherwise would have been) to some extent,” the former Dallas Fed economist says. “The decline would not occur in one fell swoop at the time the increase was enacted, but would start to emerge in the market as the probability of enactment (as perceived by investors) increased,” Viard adds.

See AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March.

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