Economists have been concerned with avoiding the type of double taxation in the current American tax code for at least 150 years. John Stuart Mill, in his Principles of Political Economy argued for a consumption tax, arguing that to tax investment and interest was both “impolitic” and “unjust.” In
Chapter II of Book V, “On the General Principles of Taxation” (par. 2.22) he elegantly discusses the costs of such double taxation.

I recently spoke with Dr. R. Glenn Hubbard, the Chairman of the President’s Council of Economic Advisers about the economics of tax reform and the President’s proposals to change the tax treatment of dividends and retained earnings.

Russell Roberts
Features Editor

“Whether I decide to pay out a dollar or retain it, whether I choose debt or equity, is driven by my judgement as a business person and not by the tax code.”
Roberts: How does our current tax system distort the way businesses raise capital and finance investment?

Hubbard: The current tax system is biased against equity financing which makes it very difficult for companies
to have a flexible capital base for good times and bad times. And it’s biased toward financial
engineering that can lead to higher leverage. In addition, especially important in the wake of the
recent corporate governance scandals, the tax code is biased in favor of retained earnings instead of
a more transparent system and greater dividend pay-outs. The administration believes those
distortions are very important. This isn’t just a long-term exercise—those distortions are important to
remedy for the here and now of the economy. That will lead to high capital formation and that
means higher wages and income for all of us.

Roberts: I know the President’s plan has a lot of bells and whistles, but I wonder if you could give us a
simple description of the way the President’s proposal would change the way the Federal Tax
Code treats dividends and retained earnings.

Hubbard: The President’s growth package has a lot more than this—there are accelerated margin rate cuts and a
variety of other things. But on the issue of the dividend plan, if companies pay a dividend to a
shareholder, the shareholder would not pay tax on the dividend, provided corporate tax had already
been paid.

For retained earnings, if the company chooses to retain the dollar, the shareholder adjusts his or her
basis by a dollar, effectively increasing the price that was paid for the share of stock. What that
amounts to is eliminating the capital gains tax on accumulated retained earnings and eliminating the
dividend tax.

Roberts: What’s the goal of those changes?

Hubbard: It does two really big things for economic growth. One is to reduce capital taxes and the cost of
capital for investment. The second is that it now makes neutral the corporate finance decision. So
whether I decide to pay out a dollar or retain it, whether I choose debt or equity, is driven by my
judgement as a business person and not by the tax code.

Roberts: What empirical evidence do we have that neutrality of that kind will effect investment and
appreciably increase capital formation?

See “Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once” (January 1992), from the Treasury Department’s Tax Policy Documents Archive.

Hubbard: About ten years ago, the Treasury Department and the American Law Institute both did very
significant studies of corporate tax integration, that is, removing the double tax on corporate source
income. Both of those studies found quite significant effects on economic activity going forward so
that one could raise the economy’s growth rate by a couple of tenths of a per cent over a very, very
long period of time. And if that sounds like small change, it’s not. Every ten years, that’s a thousand
dollars of extra income for every man woman and child in the country

Roberts: What’s the empirical basis for those estimates?

Hubbard: There are really two kinds of studies that economists have done here. One are econometric studies
of investment. But for tax changes this large, economists tend to use what are called computable
general equilibrium models. They’re models of the economy that also have assumptions about the
tax system and then you can make fairly large changes and ask where does the economy move. In
these exercises that both the Treasury and the American Law Institute did, the capital stock, the
productive capital in our economy, grew quite a bit after eliminating the double taxation of
dividends. That higher capital stock raises productivity and wages and hence consumption
possibilities for all of us.

Roberts: Trace out the connection between productivity and higher wages.

Hubbard: Think about working in a business. The more capital the business has, the more machines or
equipment to work with, the more productive an individual worker is. And so if the worker is more
productive and because labor markets are competitive in the United States, the workers will get
higher wages as businesses compete for labor. Those higher wages then mean we can all consume
more and have a higher GDP as well. It’s a really important piece of this, because a lot of the
descriptions people have given of cutting the dividend tax focus on affluent people spending out of
greater after-tax dividends.

Roberts: A Keynesian argument?

Hubbard: Yes. And that’s not the point. The point is to change incentives for investment and capital
formation. I know that sounds long term but it has very, very powerful short-term effects, too. Asset
markets, of course, are forward looking and this better tax policy has very positive effects on the
here and now.

Roberts: One of the great insights of economics is that the burden of a tax is determined by market forces
rather than by who the tax is collected from. So while the dividend tax appears to be paid by
investors, the true burden may be on other sectors of the economy. Do we have any on who bears
the burden of the dividend tax?

Hubbard: The double tax affects certainly all capital and not just corporate capital and by that link effects
wages as well. A perhaps surprising result in public finance is that the optimal or the best way to
tax capital income is not to tax it at all. Paradoxically, workers are better off with a zero tax on
capital income. To see why, go back to that same example of what happens when an economy has
more capital. If we have more capital, then wages rise, and ultimately most of that return gets
captured by all of us as workers. Not by the savers who generated the capital in the first place.
What the President has done in this package is move much closer to a world where we tax capital
less, enabling, perhaps counter-intuitively, all of us to have higher wages.

Roberts: Doesn’t that result stem from the extreme mobility of capital and investment compared to labor?
So taxes on capital push capital out of the country?

Hubbard: Yes. Were Congress to adopt the President’s plan it would be very positive for equity capital
inflows into the United States.

Roberts: The estimated loss to the Treasury from the dividend part of the President’s package is put at
about $360 billion over ten years. It’s a static estimate and doesn’t include any of the
ramifications of an increase in economic activity that you’re talking about. Do you have any
idea of what a more dynamic estimate might look like?

Hubbard: It’s an important point. Not all tax cuts are created equal. Some have very positive growth effects
and some have very trivial growth effects. If somebody’s a member of Congress voting on a tax bill,
you want to know what it actually does for the economy—that’s the whole reason you’re doing this in
the first place. We believe that the revenue feedback effects were they to be scored for the dividend
piece could be as high as 40%.

Roberts: Meaning?

Hubbard: That those static cost numbers are substantially overstated. That is, maybe 60% of them are actual
cost to the Treasury. And of course the revenue cost is still in an economy that would have higher
GDP and higher wages as a result.

Roberts: Do you think there are going to be changes at the CBO in how they score tax proposals?

Hubbard: Well the actual costs for tax bills are done by the Joint Committee on Taxation in the Congress and
by the Treasury Department here. We have conservatively used so-called static scoring in the
President’s budget—that is assuming no growth effects but describing what those growth effects are.
The Congress has to decide its own convention with the Joint Committee on Taxation.

Roberts: One of the criticisms of the President’s plan is that it adds a lot of complexity to the tax code.
Since the plan was originally released, there have been a number of tweaks as problems have
arisen. People are good at evading taxes and when you change the tax code, you want to make
sure people don’t find wasteful ways of evading taxes that lead to economically destructive
effects. Can you comment on that?

Hubbard: This is actually one of the most baffling questions I get repeatedly when talking about the plan and I
must say I don’t quite understand it. The first question we have to ask ourselves is complex, relative
to what. Current law, because of the tax bias against equity financing and the tax bias against
dividends creates a number of highly complicated financial engineering transactions that companies
and investors go through, legitimate transactions, to minimize taxes. So we’ve created an incredibly
complex system already with what we’ve done. Under what the President has proposed, it is true
that not all dividends are literally passed through. There’s something called an excludable dividend
account so you have to have paid tax at the corporate level. But our best tax lawyers in the
Administration claim that if they were in private practice only a few billable hours might be eked
out helping a major company get this set up. This is not a big deal.

And what about individual investors? As an investor, when I get my 1099, the tax piece of
information that tells me about my dividends, it will tell me, “Dear Glenn, you got this many
dividends that you don’t have to pay tax on and this many that you do.” It doesn’t strike me as that
complicated. And in terms of keeping track of the basis adjustment on retained earnings, for most
small investors that’s done through financial services companies and mutual funds who have told us
that they believe it to be quite easy to do. Indeed, Fidelity, one of the very large mutual fund
complexes has wholeheartedly endorsed the President’s plan.

Roberts: Do you think there’s any hope down the road for a more basic tax reform or tax simplification?
A lot of past plans for reform have tried to simplify the code by removing the bias against
savings. The President’s plan is a step in that direction, but it does that within the framework of
the existing tax system.

Hubbard: If you look at the efficiency gains from tax reform, the bulk of those come from corporate tax
integration, that is, removing one of the layers of tax, so I think this is a very, very big deal.
There’s certainly a need to talk further about tax reform issues. But go back to what the President
was trying to accomplish. This wasn’t a big picture discussion of tax reform, it was a response to
perceived weaknesses in investment in the economy now.

Roberts: If corporate dividends are tax free, what do you think will be the impact on municipal bonds and
their attractiveness?

Hubbard: Let me start with a story, a story I’ve used with municipal bond investors. Suppose I sat at a table
with everyone in 1975 and I told them I had perfect foresight, I could tell the future about what
marginal tax rates were going to be between 1975 and 2003 and what financial innovation would
happen. I guarantee you if I had that foresight I would have panicked everyone in the room. They
would have thought these markets would collapse. In fact they’ve had great prosperity which is to
say that our capital markets are very resilient and deep. We’ve estimated that the effects on
municipal yields are likely to be modest at best.

It’s something surely to look at, but I don’t believe it’s a very big cost.

Roberts: You’ve been involved in the issue of corporate tax neutrality and incidence for a long time. Talk
about your interest in the area and the history of economists’ views on this subject.

Hubbard: Economists have worked on it for a very long time. There are certainly waves of fashion for tax
reform in the public eye. But I think economists have worked on this for quite a long time. What’s
new in academic work in the past 20 years or so is the realization that this is extremely important for
growth and not simply for the allocation of capital. There are very responsive margins of savings,
investment and entrepreneurship. That’s what accounts for the renewed academic interest and
certainly my own. What has made this idea take center stage is the President’s great interest in
economic growth. I think this new literature has been very useful in that regard.

Roberts: Some might say that’s rather surprising. Politicians usually are accused of having a short-term
focus. And while there may be some short-term gains as you suggest, much of the benefit from
fundamental tax reform and increased capital formation is surely in the long-term.

Hubbard: I’m not a very political person. But I have observed in this President a great concern about
long-term growth. I think it’s a credible political as well as economic and political story to say
you’re concerned with long-term living standards. I think the American people are much smarter
than many politicians give them credit for.

Roberts: What do you think is the connection between tax reform and liberty, between our freedoms and
how our taxes are structured?

Hubbard: I think it’s a very important connection. People’s faith in the tax system and the government depends
on a transparent and easy to understand and not particularly burdensome tax system. If you have a
situation in which I always believe that you’re somehow getting an advantage because you have
some special deal or you’re cleverer with the tax code than I, it really undermines my faith in
government so I see this as being very important.


*R. Glenn Hubbard was appointed by the President on May 11, 2001 as Chairman of the Council of Economic Advisers. He received his Ph.D. in economics from Harvard University in 1983. Dr. Hubbard is on a leave of absence from Columbia University where he is the Russell L. Carson Professor of Economics and Finance and Co-Director of the Entrepreneurship Program in the Graduate School of Business and Professor of Economics in the Faculty of Arts and Sciences.

*Russell Roberts is a professor of economics at George Mason University and a research fellow at Stanford University’s Hoover Institution. He is the Features Editor of the Library of Economics and Liberty and the host of EconTalk.

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