Arnold Kling

More on Dividend Taxation

Arnold Kling, Great Questions of Economics
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If nothing else, President Bush's economic stimulus plan has shined a spotlight on dividend taxation. It is the topic du jour on economic web sites.

One issue concerns whether or not a dividend tax cut constitutes a stimulus. If you believe that it will raise the wealth of shareholders (which depends on the way that stock prices react), then it would be a stimulus, according to Ryan Lizza.

What worries Hubbard and the White House is that more than $7 trillion in value has been wiped out of the stock market over the last three years. According to the wealth effect, consumption should be plummeting in the wake of the market's decline...wealth effect advocates also attribute the continued spending to the slow pace at which investors fully adjust to their decreased wealth. In other words, the predicted drop in consumption may well kick in this year.

Lizza cites a paper that GQE noted almost a year ago by Maki and Palumbo, which shows that wealthy shareholders do alter their consumption in response to stock price changes.

A second issue concerns the alleged inefficiency of the double taxation of dividends. Zimran Ahmed writes

It is really very simple -- taxing dividend income at a higher rate than capital gains means that companies will substitute from returning money to shareholders through dividends to returning money to shareholders through share buybacks...

Eliminating this difference in taxes eliminates this distortion -- companies will do whatever is best for them and their shareholders. This will marginally improve the efficiency of the economy, which is non-consequential in the short term, but really valuable in the long term. It will provide no real fiscal stimulus, nor will it seriously erode any tax base -- it's kinda like remembering to shut the door to the refirgerator, or squeezing toothpaste from the bottom of the tube -- it's just good sense.

My comment on this is that we should remember the Theory of the Second Best. That is, in an economy with multiple distortions, we cannot say for certain that removing one distortion improves efficiency. The taxation of capital income in this country is so wildly contorted that I would be hestitant to label any incremental change as "just good sense."

Meanwhile, as Brad DeLong points out, we probably all had better read the proposal, because it apparently goes beyond dividend exemption.

Discussion Question. If the dividend tax cut proves to be stimulative, what are the factors that would make its effects felt sooner or later than those of another type of tax cut?

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