President Bush’s economic proposal is pure supply-side. The guiding principle is the elimination of double taxation — be it on dividends, death, or savings. The opposition to the plan is understandable, since the critics do not believe in the supply-side story. It should not be surprising then that their analyses do not incorporate many of the substitution effects that are vital if the plan is to succeed.
The main voice in favor of the plan is none other than good friend and fellow supply-sider Larry Kudlow. He correctly argues that we have had a stock-market recession and that we need a stock-market stimulus to get the economy going again. But not only will the Bush plan get the economy back in gear. Evidence from previous tax-rate changes suggests that the positive supply-side impact of the plan will be even larger than the administration suggests.
The first step in understanding the full impact of the plan is to understand that the elimination of the double taxation of dividends will alter the way returns are delivered to investors. To see this one has to focus on the amount of cash that an ongoing concern generates. Under current conditions the objective of a corporate manager is to deliver that cash to investors in the least costly manner. The options available to the corporation are debt, dividends, and capital gains.
A big deal is being made over the fact that the Bush tax break is being given to the shareholders not the corporations. The people who grumble over this either failed or never took Public Finance 101.
Consider the example of $100 worth of corporate earnings pre-tax.
Case 1: The current tax law is operative and both the corporate tax and personal income tax on dividends are 35%. The $100 will net $65 after taxes to the corporation. Once the shareholder receives $65 he will net only $36.40 after all taxes are paid.
Case 2: The double taxation is eliminated at the shareholder level (the president’s plan). The corporation will pay $35 in taxes and the shareholder will receive $65.
Case 3: The double taxation is eliminated at the corporate level (an alternative plan on Capitol Hill). No corporate taxes will be levied, the corporation pays $100 in dividends and the shareholder is liable for $35 in taxes, netting $65 after taxes.
The example shows that in cases 2 and 3 the shareholder nets $65 irrespective of how the taxes are collected, making the two forms of taxation equivalent. By eliminating the double taxation the shareholder now nets $65 and that is $28.60 more per $100 worth of pre-tax corporate income. The shareholder’s after-tax income increases by nearly 79%.
So either way you slice it, more money will go into the pockets of shareholders. And if that increase in after-tax cash does not translate to an increase in share prices and a change in corporate behavior for the better, nothing will.
History, again, can be our guide. The natural supply-side response to the Reagan tax-rate cuts was for investors to attempt to minimize the impact of taxes on their cash flow. In 1982, per every $100 of corporate cash flow, an investor could generate an additional $6.80 worth of after-tax income by switching $100 worth of capital gains to corporate debt. The same calculus shows that the investor would generate an additional $16.20 by switching $100 worth of dividends into interest income.
Given those incentives the logical economic response in the 1980s was to convert dividend and capital-gains income to corporate-debt interest income. This is exactly what happened. And that’s why Michael Milken owes his fortune to Reaganomics.
Those who do not share in the bullishness of the Bush proposal in general tend to dismiss the magnitude of the substitution effects that the proposed tax realignment will bring. The evidence suggests that these substitution effects are quite large and that it is perilous to ignore them. Should the Bush plan go into action, the after-tax cash flow of corporate debt will rise by 5%, capital gains will climb by 25%, and dividends will surge by 65%. These are pretty large increases in incentives.
The elimination of the double taxation of dividends will increase the relative attractiveness of the dividend over capital gains, and as such there will be an increase in dividends. However, capital gains will not be hurt in the process, as the elimination of the double taxation will increase the after-tax retention rate of corporate income and thus spur a higher market valuation.
The Bush economic program will change the economic landscape for the better and its impact will be felt for years to come. Once the dynamic effects of the plan start working, the market gains will be well in excess of the static gains delivered by the tax cut.