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January 07, 2003

Bush's Trick Rhetoric-- Dividends vs. Capital Gains

In announcing his plan to leave dividends untaxed, there was an additional argument by Bush for his plan:

The president said the centerpiece of his proposal -- the complete elimination of federal income taxes on stock dividends -- would help correct an imbalance in the tax code under which dividends are now taxed at a higher rate than profits from stock sales.
Now, it's worth remembering that the reason taxes on profits from stock sales are lower than the tax on dividends is because the GOP pushed through a bill a few years ago to tax capital gains at a lower rate than ordinary income.

How was that justified? A large reason is that, unlike dividends, capital gains from stocks are measured over many years. Because of inflation, it was argued by conservatives, increases in stock values based only on inflation and not real gains get taxed. See this analysis in 1994 by the conservative National Center for Policy Analysis that was used to argue for the capital gains tax cut once the Gingrichites took over Congress.:

Because investors must pay taxes on gains that merely reflect the effects of inflation, the effective tax rate on their real gains can be extraordinarily high. For example, someone who invested in common stock in 1970, did as well as the Dow Jones Industrial Average and sold the stock in 1980 would have had a capital gain of 18.4 percent. During this same period the price level more than doubled, so the nominal gain actually represented a real loss of 44 percent. Nevertheless, the investor would have been assessed a capital gains tax.
Lowered capital gains tax rates was considered a simpler alternative to indexing all stock increases to inflation, a bit of a bookkeeping nightmare.

Now, whatever the merits of this argument, there is a fishy trick being played here. Having made the argument that capital gains should have a lower tax rate versus yearly income, such as wages or dividends, conservatives are now using that lower capital gains tax rate to cry that there is an unfair differential between the tax rate on capital gains and on dividends.

We can expect, once this dividend tax cut goes through, that within a few years conservatives will be rearguing that the problem of inflation means that the tax system is biased against stock sales and capital gains, so they need a new cut in capital gains taxes.

Posted by Nathan at January 7, 2003 03:25 PM

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