LegiStorm

Summary:

The tax treatment of dividends has changed numerous times over the past century. Most recently, the American Taxpayer Relief Act (ATRA; P.L. 112-240) increased the tax rate on dividends, from 15% to 20%, for taxpayers in the top income tax bracket. The change was effective for 2013. Also effective in 2013 is the 3.8% tax on net investment income for taxpayers with modified adjusted gross income above certain thresholds ($200,000 for single, $250,000 for married filing jointly). Further increases in the tax rate on dividends may be considered as part of a base-broadening, rate-reducing tax reform. Rough estimates suggest that taxing dividends as ordinary income could raise enough in revenue to offset a 1.3% reduction in individual income tax rates, which would reduce the top marginal rate from 39.6% to roughly 39.1%. If the revenues were instead used to reduce corporate rates, the corporate tax rate could be reduced by roughly 4.6%, from 35% to roughly 33.2%. House Ways and Means Committee Chairman Dave Camp's tax reform discussion draft, the Tax Reform Act of 2014, proposes that dividends be taxed as ordinary income, but provides an exclusion of 40% for dividend and capital gain income. Before 2003, dividends were taxed as ordinary income. The tax rate on dividends was reduced as part of the Jobs and Growth Tax Reconciliation Act of 2003 (JGTRRA; P.L. 108-27). Tax rates on dividends were reduced in 2003 to address some of the economic distortions that result from taxing dividends at both the corporate and individual level. Taxation of dividends in both the individual and corporate income tax systems leads to a preference for non-corporate as opposed to corporate investment. Taxation of dividends at both the corporate and individual levels also creates a bias in favor of debt-financed investments, where interest payments are deductible. The reduced tax rate on dividends at the individual level reduces, but does not eliminate, tax-induced distortions in the allocation of capital. Integrating the corporate and individual tax systems, such that capital income is taxed only once, could further improve the allocation of capital in the economy. Rather than increasing taxes on dividends in a base-broadening tax reform, integration may be considered as an option for reducing tax-induced economic distortions. Options for integration include shareholder imputation credits (individual-level credits for corporate taxes paid), a dividends paid deduction, or a dividend exclusion. A trade-off to consider with integration proposals is the budget impact. If integration policies are deficit financed, higher interest rates could crowd out economic growth. Open-economy considerations, in a globalized economy with trade, might also motivate changes in the tax treatment of dividends. Taxing dividends at ordinary rates at the individual level, using the additional revenues to reduce corporate rates, could encourage capital investment in the domestic corporate sector. Increasing taxes on dividends at the individual level would likely increase the progressivity of the U.S. tax system. Correspondingly, a decrease in taxes on dividends would tend to decrease the progressivity of the overall tax system. Ultimately, any change in dividend tax policy is likely to have economic, distributional, and revenue consequences. The trade-offs between these various objectives are something to be considered by policymakers.