Dividends in the US are doubly taxed.

Posted By: Russell
Date: 6/10/08 1:08p.m.

Report: outside forum guidelines

In Response To: Not dissing dividends (Arlyn Stewart)

Consider a bank that makes money by paying 3% on savings accounts, while loaning it at 7% to local businesses, earning 4% on capital. The bank's profit is that 4% return on capital, less other expenses that we'll pretend are zero, for the convenience of the example. Note that the 3% interest the bank pays depositors is a cost. It pays tax only on that 4% that it has after paying depositors. Now, consider a company that makes widgets. It earns 7% return on capital, and pays its investors a 3% dividend. So if it were taxed like the bank, it would pay tax on the 4% profit it makes. But it's not taxed like the bank. It pays taxes on the 7% it earns on capital (again ignoring all other costs), before paying dividends. In fact, it can lower its tax burden by keeping the money it would pay in dividends and reinvesting it in a variety of ways. Because of this quirk in US tax code, domestic companies are in fact discouraged from paying dividends. To get a dividend, stockholders essentially pay a corporate profits tax and then whatever tax they pay personally. Many company managers reason that it makes more sense to spend that money on expansion, hoping to return it to the investors as capital gains. When Bush reduced the dividend tax, he essentially returned some incentive to companies to pay dividends. Which I think generally is a good thing. Note that the double taxation of dividends is also different from how a partnership works. If, for example, you invest in an oil venture as a partner, it typically returns all profit after expenses to the partners. The partnership pays no taxes, since those profits simply "flow through" to the partners, who pay taxes as their individual circumstance prescribes. So in addition to discouraging dividends, this tax quirk constrains how various investment ventures typically are organized. Now, on the personal side of the ledger -- i.e., ignoring corporate taxation -- I agree that there is no rhyme or reason to treat dividend income any differently than interest income or other unearned income. The cut in dividend tax will expire in a couple of years. What bothers me about that is the discouraging of dividends. The obvious way to fix that is to not tax corporations on what they pay out in dividends.