Politics & Policy

Capital Connection

A wrinkle in the Bush plan spells cap-gains relief.

I haven’t been much of a fan of the proposal to eliminate taxes on dividend income. But a new wrinkle in the Bush administration’s tax plan is making a believer out of me. What our growth-challenged economy needs most right now is a cut in capital-gains taxes, to spur new investment and new risk-taking — and this new wrinkle is a clever way of transforming dividend tax relief into just that.

  

As described in internal policy documents circulating the White House and Treasury Department, the Bush tax plan will include a provision for “deemed dividend reinvestment plans,” or DDRIPs. The name is a little confusing — the provision would not create a new kind of shareholder account or stock purchase plan. Rather, a DDRIP would be a notional “account” — an accounting category on the books of a public company — to record the value of retained earnings that have been subject to corporate income taxes. When a shareholder sells stock, any per-share growth in the company’s DDRIP account would be deemed dividend — and dividends would now be tax-free — thus reducing the amount of capital gains subject to taxation.

Suppose you buy a stock at $100. Over the next year, the company makes $2 per share in earnings, after paying corporate taxes. At the end of the year, you sell the stock at $110. Instead of paying capital-gains taxes on your whole $10 gain, you get to exclude the $2 in earnings — just as though it had been paid out in the form of a dividend. You only pay capital-gains taxes on $8 instead of $10 — effectively, it’s a 20% reduction in capital-gains taxes.

In terms of its effect on economic growth, the capital-gains tax is the cruelest tax of all. It is a direct penalty on capital — and capital, in the end, is the one and only source of real economic growth. Tax capital, and you get less growth.

Dividend tax relief in isolation would have done little to remove this penalty on capital. But now it looks like we have a capital-gains tax cut on the table.

There are many details that remain to be worked out, including deciding whether to start DDRIP accounts at zero, or to grandfather in some number of years of past-taxed retained earnings. It is also not clear how the tax advantage of DDRIPs would accrue to a shareholder who realizes a capital loss, or for whom the change in basis due to DDRIPs converts what otherwise would have been a capital gain into an effective capital loss. And most important, it isn’t law yet.

One surprise that may help it become law is the fact that, for many years at least, the DDRIPs provision may be a revenue gainer for the U.S. Treasury compared with dividend tax elimination in isolation. According to a Treasury official I spoke to, the DDRIPs provision can be expected to defer dividend tax elimination to whatever time in the future a stockholder decides to sell his stock. Without DDRIPs, companies might be moved to pay out retained earnings as dividends immediately — thus accelerating any tax revenue losses to the Treasury from dividend tax elimination.

But all that said, if these proposals do become law, we could be looking at the most exciting pro-growth tax policy since the Reagan years. And after three miserable years of the worst bear market in a generation, and after 15 years of wandering in the tax-policy wilderness, it may just be morning in America again.

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