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Accelerating and making permanent the Bush tax-rate cuts of 2001 is an important first step. The acceleration reduces the disincentives embodied in the phase-in and also reduces the paperwork and regulatory burden imposed by the transitory nature of the current tax program. The benefits to the economy are obvious: The lower tax rate allows investors and shareholders to keep a higher after-tax income. That in itself will lead to a greater incentive to work, save, and produce, as well as higher asset values. The personal-income-tax rate cut will have some unintended consequences. As long as there is a corporate tax, a reduction in the personal-income-tax rate will confer an advantage to debt financing over equity financing. If history is any guide, the market response will be to increase the corporate-debt exposure and quite likely the fragility of the financial system. One simple way to eliminate these undesirable and unintended consequences is to eliminate the corporate income tax. Treasury Secretary Paul O'Neill is on record as favoring this approach. The problem with his proposal is that it's only part of his overall economic vision — which is somewhat weak. O'Neill prefers targeted incentives to a broad-based rate cut. History shows that targeted incentives do not work at the margin. More, they generate a lot of the undesirable effects that should instead be rooted out (e.g., Americans will try to get into the preferential tax brackets). One way to redress these perverse incentives is to restructure the tax code incentive system. Eliminating the corporate tax would be a novel and desirable way to start to achieve this, yet the political reality will not allow it. So, a second-best proposal is to make each of the return delivery mechanisms equally attractive to corporate managers and investors. Eliminating the double taxation of dividends will get us close to this. As a practical matter, dividends should be made taxable to corporations and exempted to shareholders. This will produce the awkward situation where interest debt is deductible to the corporations while dividend earnings are not. On the other hand dividends will not be taxable to individuals while interest income will be. So, in this scheme, it is easy to see that both interest income and dividends are taxed only once. More, the advantage of doing it this way is that we do not need to change the current infrastructure for tax-revenue collection. And politically the elimination of double taxation would be sold as a tax brake for widows and orphans (i.e. dividend recipients). Another benefit is that it will increase the political pressure to make the corporate- and personal-income-tax rate the same. Now all we need to add is the elimination of the capital gains at the corporate level and we have moved the tax system a long way towards the objective of making investors neutral to how they receive their returns. The proper signals will be sent economy-wide, too. Productivity and output will rise and the markets will react positively. If everything works out, all that will be left to do in the future is simplify the tax code by moving directly to a single-rate tax code. The elimination of the double taxation of dividends will reduce the attractiveness of corporate debt and increase that of dividends. In due course, we will see corporate debt issuance fall and the net issuance of equity increase. However, it is important to note that the elimination of the double taxation of dividends does not punish corporate debt — it only makes equity more attractive. Within the corporate structure there will also be some changes. Dividends will become more popular and there should be an increase in the dividend yield of corporate stocks. An immediate thought is that dividend-intensive stocks would greatly benefit from the tax-rate cuts. The elimination of the double taxation of dividends will also favor "cash flow" generating businesses, who will be able to deliver income as a simple dividend as opposed to having to deliver capital gains. An example illustrates this point. Consider the case of Microsoft, a company sitting on better than $40 billion in cash. If they declare a dividend investors would net only about $24 billion after paying the IRS dividend tax. On the other hand that cash — if it is never spent — raises the market cap of Microsoft by $40 billion and shareholders, by selling the stock, could keep $32 billion after paying the capital gains. The problem with the latter option is that it forces the shareholders to divest themselves of Microsoft in order to capture the value of the cash. Investors may not want to do that; if they believe in the company they may want to hold on to the stock. Viewed this way it is apparent that the current situation bundles investor choice. Elimination of the double taxation of dividends will force companies like Microsoft to declare the dividend and let investors do what they want with their cash. The elimination of the double taxation of dividends will lead to the unlocking of capital that will make the U.S. economy more efficient. |
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resident Bush has a wonderful opportunity to increase the economy's efficiency,
growth rate, and market values. While he has not yet made the specific
details of his new economic plan public, during the campaign he was clear
and specific on the direction he wanted to take the economy — upward.
If George W. Bush follows his supply-side instincts he may very well launch
us into another virtuous economic cycle. 
