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Deformed Reform
Senate Finance has altered the Bush plan from recognition.


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Donald L. Luskin

President Bush’s proposal to eliminate the double taxation on dividends was simple, moral, and innocent — a lot like Jefferson Smith, the James Stewart character in Frank Capra’s classic film, Mr. Smith Goes to Washington. And just like Smith, Bush’s proposal got corrupted, chewed up, and spit out by the U.S. Senate.

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The version of dividend tax reform proposed by the Senate Finance Committee last week corrupts fundamental tax reform into populist pandering and makes the tax code more complex. Perhaps worst of all, it fails to resolve the long-standing unfairness of taxing this kind of income twice, and at the same time it introduces whole new categories of unfairness to the tax code.

Bush’s proposal last January to end the unfair double taxation of corporate dividends and retained earnings was an act of extraordinary integrity and courage. It was no mere “tax cut.” It wasn’t just a grandstand gesture aimed at attracting votes or PAC money. Not many, in fact, had clamored for it on Main Street or Wall Street.

This was a tax-cut proposal from the heart: Bush requested it because it was the right thing to do. It was a down payment on fundamental tax reform in America. Bush knew it wasn’t right to tax a shareholder’s profits once when a company first earned them, and then again when they were transferred from the corporate treasury to the shareholder’s bank account. (That’s all that goes into paying a dividend; it’s a transfer). Bush knew that this was not only morally wrong, but also tragically inefficient. He understood that it put a disproportionately heavy burden on that which makes any economy grow and prosper: invested capital.

Bush’s proposal was brilliantly egalitarian and simple. Whether you’re rich or you’re poor, whether you own 100 shares of stock or 100 million — all dividends would be tax-free from now on. Under the Senate’s plan, only a taxpayer’s first $500 in dividends would be tax-free. That means if you own about $25,000 worth of a typical dividend-paying stock (but no more than that), then you will be one of the lucky ones. You will be freed from unfair double taxation.

But for the rest of us, only 10 percent of dividends will be excluded from taxation after the first $500. The rest will be treated like ordinary income. That exclusion rises to 20 percent in 2008 (are you writing this down?). Then, in 2013, the whole thing reverts back to what it is today.

Under Bush’s plan, however, everyone would have been a winner, and in the same proportion. If you receive dividend income, you would have received a tax cut that would have left you more money to save, invest, or spend. If you own stocks, you would have seen a one-time jump in their value as the market adjusted to higher after-tax yields. All this might have come as quite a relief to the millions of Americans who are trying to get by on their savings and investments in an age of near-zero interest rates. But all of this is no windfall — it is just the belated reversal of a systematic unfairness that has been in place for sixty years.

Even if an American worker does not own a single share of stock, he is still a winner under the Bush plan. Why? When investors expect a higher after-tax return on invested capital, they will supply more capital to the businesses that need it to expand, upgrade, and innovate. That translates directly to new jobs and higher wages for existing jobs, because expansion, upgrading, and innovation create the demand for new workers, and make existing workers more productive.

Yes, it just so happens that his particular form of fundamental tax reform would have profound pro-growth implications. Bush wanted a lot of reform and it would have led to a lot of growth. And that growth would have led to a lot of new tax revenue. It would take an Ivy League economist, or a static-thinking Washington bureaucrat, to fail to see that.

So the Senate Finance Committee, fearing that its shrunken and twisted version of Bush’s dividend tax reform will contribute to budget deficits, has had to invent whole new forms of tax unfairness to make up for the shortfall.

First, while they’ve slightly reduced one kind of double taxation, they’ve created an entirely new kind. Under the Senate plan, Americans working abroad will from now on have to pay income taxes twice — once in the foreign country in which the income is earned, and again in the United States. Second, Americans who choose to emigrate to another country will be charged what amounts to an “exit penalty”: a tax on their unrealized capital gains — money they haven’t even earned yet.

Then there’s the provision of the Senate Finance Committee’s plan that would create a $20 billion “fund” to bail out profligate states who spent themselves into a pickle and now don’t have the courage to tighten their belts. This hasn’t received much publicity, but one particularly obscure little sentence in this section deserves more than a bit of public scrutiny: “The purposes of the fund could include additional measures to ensure that fiduciary attorney fee standards are adequately respected.” Need I say more?

When Bush first proposed ending the double taxation of dividends, it was in fact honest, real reform. Thanks to Senate Finance, it’s now reform deformed. It has been altered from recognition, becoming just another overly complex, unfair, and politicized tax bill. We can only hope that as the proposals of the Senate Finance Committee are reconciled with the version of the tax-bill approved last week by the House of Representatives — a version that is much truer to Bush’s original — that the president will remind the American people of the value and the rightness of real reform, and that the American people will echo his reasoning to their elected representatives.



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