Higher corporate and investment tax rates hamper U.S. competitiveness

A report by Ernst & Young LLP, commissioned by the American Council for Capital Formation, compares individual long-term capital gains taxes among 25 major economies of the world, as well as major trading partners of the U.S. The U.S. capital gains tax rate compares unfavorably: more than half the countries surveyed have lower individual capital gains tax rates than the U.S.

It’s a similar story on the corporate tax front. According to the Organization for Economic Cooperation and Development (OECD), the U.S. currently has the highest corporate tax rate, at 35%, of any industrialized nation. Reducing that rate to 30.5% would be a step in the right direction, but would still only leave the U.S. with the fifth highest corporate tax rate in the world.

Policymakers have long recognized the reality that high corporate taxes are damaging to competitiveness. In 2010, the National Commission on Fiscal Responsibility and Reform concluded that a high corporate income tax “hurts America’s ability to compete. On the one hand, statutory rates in the U.S. are significantly higher than the average for industrialized countries (even as revenue collection is low), and our method of taxing foreign source income is outside the norm…. The current system puts U.S. corporations at a competitive disadvantage against their foreign competitors.” (emphasis added)

The ASI coalition believes that reducing the U.S. corporate tax rate and mitigating double taxation of corporate income are among the most important changes Congress can make to today’s tax code.

U.S. investment taxes are already among the highest in the developed world

A 2015 study by the leading business consultancy firm EY illustrates how U.S. investment tax rates are among the highest of developed nations, which has serious implications for U.S. competitiveness and economic growth.

Those high tax rates have real-world effects. Companies have always needed investment capital to survive, prosper and grow. They are making decisions today that will impact business operations for years to come, like hiring, research and development, and expansion—all of which require capital funding from investors.

High capital gains and dividend tax increases reduce the incentive for new investors to purchase stock, drying up a vital source of permanent capital for companies looking to grow. As the tax reform debate shapes up, Congress should focus on policy reforms that promote, rather than discourage investment.

Double taxation of investment income discourages companies from paying dividends

Corporate profits are taxed twice – first at the corporate level, and later at the individual level when companies pay dividends to their shareholders. This double taxation will be exacerbated if (1) the dividend tax rate were to increase; and (2) the tax rates for dividends and capital gains were to be “decoupled.”

A sharp rise in the dividend tax rate would discourage corporations from paying dividends to their shareholders, because they would see tax advantages from retaining their earnings instead. Most economists, tax experts and market observers agree that corporate decisions of this type should be based solely on non-tax considerations.

As the administration and Congress focus on tax reform, they should seek to remedy the double taxation of corporate profits, including a potential corporate-level partial deduction for dividends paid to shareholders.

Tax increases on dividends disproportionately affect seniors

Advocates of higher investment taxes on dividends and capital gains suggest only “the wealthy” will be subject to the higher taxation levels. Don’t believe it. Senior citizens and those nearing retirement age represent a substantial portion of investors who own dividend-paying stocks. As such, they would face the heaviest burden of higher taxes on investment income.

It is clear that seniors, many of whom live on fixed incomes and draw upon retirement savings accumulated over a lifetime of work, earn the lion’s share of dividend and capital gains income. Allowing these tax rates to rise would disproportionately hurt older Americans.

The economy benefits from lower capital gains tax rates

A Small Business & Entrepreneurship Council analysis found that over the past century, there have been five instances of substantive cuts in the capital gains tax. In each case, the economy benefited from these reductions. In contrast, there have been two instances where an increase in the capital gains tax clearly had a negative impact on the economy:

  • The capital gains tax rate steadily rose from 25% to 49.1% over the period from 1968 to 1976, and over that time average annual real economic growth underperformed the post-World War II average (3.0% vs. 3.5%).
  • With the capital gains tax hike in 1987 came slower economic growth. From 1987 to 1996, real annual GDP growth again under-performed – averaging only 2.9% compared to the post-World War II average of 3.5%.

Higher taxes on capital reduces both wages and federal revenues

A 2009 report from the Institute for Research on the Economics of Taxation finds that increasing taxes on investment capital would damage the economy and reduce the tax base. In fact, higher investment taxes are likely to result in lower federal revenues, larger budget deficits and an ever-growing national debt. Higher tax rates on capital income would discourage investment and result in a smaller capital stock.

Higher taxes on investment will impact the middle class

The level of taxes on dividends has an inverse relationship to the number of companies that pay a dividend. So if the tax rate on dividends increases—even if it’s only for high earners – less dividend money will be paid out, hurting investors at all income levels.

A CATO Institute study examined this relationship in the first year following the 2003 dividend tax cut. Annual dividends paid by S&P 500 companies rose from $146 billion to $172 billion. In addition, 22 companies that did not previously pay dividends initiated regular dividends, and equity values rose more than $2 trillion after the tax cut. These outcomes illustrate how lower taxes on investment can foster more economic activity and growth.

Higher tax rates on dividends discourage equity financing

Higher dividend tax rates can reduce the perceived value of a company’s stock and reduce the incentive for new investors to become shareholders. Because corporate interest expenses are tax deductible, while dividend payments are not, higher taxes on dividends encourage corporations to favor debt financing over equity financing. This distorts corporate investment patterns, and could place some companies at greater risk during periods of economic weakness.

A Bloomberg Government report looked at studies conducted in 1992 by the Treasury Department, looking specifically at the effects of a dividend exclusion provision, whereby individuals would exclude dividends from their taxable income, eliminating the double taxation of dividends. Bloomberg found that the exclusion of dividends “may help to encourage companies to increase dividends, giving them more financing, and reduce borrowing, which reduces their debt financing.”

Additionally, Bloomberg notes that, “If the tax on dividends is reduced, companies that already pay high dividends per share…may see an increase in investment in their shares without having to change their current dividend payout structure.”

Dividends make corporations more transparent and accountable to their shareholders

Policymakers interested in improving corporate governance should seek reforms that encourage businesses to pay dividends. Dividend payments force companies to have cash from real (not paper) profits in order to pay dividends to shareholders. Dividend payments are the ultimate form of accounting transparency. A lower dividend tax rate lowers the effective tax rate on corporate earnings. This low rate can influence managerial behavioral and delivers a number of economic benefits:

  • Better corporate governance and more efficient resource use: Low dividend tax rates make paying dividends a more attractive proposition for companies than retaining earnings; this promotes a more efficient allocation of capital and give shareholders, rather than executives, a greater degree of control over how a company’s resources are used.
  • Higher stock prices and healthier balance sheets: Low dividend tax rates make investing in equity more attractive to investors, helping stock prices and making it easier for companies to finance new investment by issuing new shares of stock rather than by issuing debt. This means less debt financing and healthier corporate balance sheets, reducing the risk of bankruptcy during hard economic times.