Nine years ago this month Congress passed President George W. Bush’s Jobs and Growth Tax Relief Reconciliation Act. That bill’s lower rates on capital, as well as the continuity in tax policy it established, have helped make our economy far more resilient.
The legislation’s centerpiece was a reduction in the taxation of dividends and capital gains to 15%. Unfortunately, the 2003 tax rates, including those on capital income, are due to expire at the end of the year.
Capital warrants special tax treatment because of the central role it plays in generating economic growth and jobs. Capital is the very lifeblood of the market economy, the mainstay of innovation, and the foundation for future prosperity. As more of it is put to work today, labor output and wages will rise tomorrow. An appreciation of that critical relationship should guide how the tax system treats earnings from capital.
The double taxation of dividends—with corporate earnings first taxed 35% at the corporate level and then, when paid out to shareholders, taxed again—has been a long-standing and well-recognized distortion in the tax code. It favors debt financing over equity capital formation, because interest is deducted as a cost of doing business and lowers taxable income, while dividends are taxed twice.
The preference for debt financing and leverage shortchanges shareholders and is not healthy for corporate decision-making. Double taxation penalizes dividend payments and discourages managements from making them.