We'll begin with hypothetical citizen Susan, who is the sole shareholder of a privately-held corporation known as Wireless Telecommunications Fidelity (if it were to go public the ticker symbol would surely have to be WTF). Although Susan owns the corporation, she is not actively involved in the day-to-day running of it, because she is spending the majority of her time making $250,000 a year as an attorney. For many years WTF has been growing like a weed by reinvesting almost all of the company's earnings in expansion, resulting in profit growth and the employment of many new people. Susan has not taken much in the way of dividends out of the corporation, but now she plans to since growth has leveled off. It is July of 2014, just after WTF has closed out its fiscal year on June 30th. The company has pre-tax earnings of $1,000,000 on which it must pay corporate income tax at the rate of 35%--a tax of $350,000, leaving $650,000 to pay to Susan as a dividend.
Now, we are starting with pre-tax earnings of the corporation to underscore two critical points. First, Susan is the owner of the corporation, and that means that the $1,000,000 in earnings belong to her, just the way her $250,000 salary belongs to her--but she has to pay taxes on both, either at the corporate level or the personal level. Second, we need to remember that the money used to pay Susan her dividend has already been taxed at 35%. The vast majority of the corporation's expenses were tax-deductible (wages, raw materials, etc.), but not the money paid out as dividends. For example, the interest that WTF paid to its bondholders (creditors) was deductible as an expense, so the bondholders have to pay tax on that interest as ordinary income. The same is true for Susan's salary, as the law firm that pays her was able to deduct that as a business expense. This is what is known as the "double taxation" of dividend income.
Now Susan has her dividend of $650,000, which would have been taxed at 15% under the tax arrangement known as the "Bush tax cuts." This tax would have amounted to $97,500, leaving Susan with $552,500. So, out of the $1 million she started with, Susan gets to keep 55.25% after paying 44.75% to Uncle Sam. Unfortunately for Susan, though, the Bush tax cuts expired on schedule, and now her dividend, pursuant to the tax plan that President Obama advocates, will be taxed as ordinary income, at 39.6%. But that is not all, because ObamaCare adds another tax of 3.8% on Susan's investment income, so now the rate she will have to pay on her dividends is 43.4%, almost triple the 15% rate that prevailed until 2013. Instead of paying the IRS $97,500, Susan will have to pay a tax of $282,100, leaving her $367,900. If you are keeping score, Susan has turned over 63.21% of her WTF earnings to the government.
Susan plans to leave her entire estate to her only son. Of course the value of the corporation that Susan owns will put her estate well over the $5 million personal exemption that prevailed as part of the Bush tax cuts, so some estate taxes will have to be paid. Unfortunately for Susan again (or at least for her son), the Bush tax cuts have expired, as advocated by President Obama, and the personal exemption is now cut to just $1 million. The estate tax rate has gone from 35% under the Bush tax plan to 55% per the Obama plan. The $367,900 that Susan kept after paying corporate taxes and income taxes will shrink to $165,555 after her estate taxes of $202,345 are paid.
To review, we followed the money as the Obama tax plan reduced Susan's $1 million to just 16.55% of that amount, after she handed over a total of $834,445 to the government. Even under the Bush tax rates, Susan's original $1 million would have shrunk to $359,125, so the Bush tax rates weren't exactly absolving her of a major tax contribution. The addition of insult to injury is that President Obama's plan reduces her amount by another 54%. Yep, you really better start with a very large fortune if you want to end up with a small one.
President Obama's latest campaign move--and it's a pretty clever one--is to say that he favors extending the Bush tax cuts only for couples making less than $250,000 per year. Some people who say that "the rich" should pay more taxes would likely define "rich" as anyone who makes, or has, more money than they do. If I make $99,999 a year, then sure, raise taxes on everyone who makes $100,000 and up. That move is designed to fan the flames of class warfare and gain favor with a majority of the electorate. (Here, that arsenic will go down a lot easier with this spoonful of sugar.) That's politics, but we are dealing with real money here--and the real economy. What about the argument, actually a Keynesian one, that raising taxes is really a bad idea in an economy that could be slipping back into recession? The folks whom I'll call the Tax Advocates make the case that tax cuts should only be for those below a certain income threshold, because their marginal propensity to consume is higher than it is for people who are "rich." In other words, people with lower incomes will spend more of their last dollar of disposable income on consumption, which is the stimulus that the economy needs. The rich, in contrast, supposedly have all of the plasma televisions, cars, and yachts that they need, so they will not, on average, spend that much of their tax cuts. Of the many problems with that argument, we'll just point out that there are only two things that you can do with money--either spend it (consumption) or save it (where it becomes available for investment). The Tax Advocates present an argument that at least implicitly views all money flows as income, as if the only thing money were needed or used for is to pay living expenses. Once they've painted that picture, it becomes easier to villify anyone who might be on the receiving end of a much more substantial money flow that should actually be categorized as investment capital. Of Susan's original $1,000,000, taxes sucked $834,445 of investment capital right out of the private economy. What the Tax Advocates do is make an argument to the electorate that they are taxing income, when what they are really doing is taxing wealth--otherwise known as savings and investment capital.
Another problem with the Tax Advocates is their perennial tendency to view the economy as static, when it is in fact dynamic. That is, they fail to account for the fact that people change their behavior in response to economic incentives and disincentives. Let's suppose for a moment that the tax rate on dividends were to go up to 99%. Unless Susan's accountant earned his business degree at Faber College (as in Animal House), he would certainly have advised her to rethink that dividend from WTF. Does anyone, even the most ardent socialist, really believe that corporations and their shareholders are just going to keep the same old financial policies in place when confronted with a tripling of the dividend tax? As we get closer to the end of the year--and particularly after the November elections--the more likely it appears that the Bush tax cuts will indeed expire, the more likely that some corporations will accelerate dividend payments to get those done this year, before Taxmageddon on January 1, 2013. Consider this article from The Wall Street Journal detailing how reported dividend income rose after the Bush tax cuts were enacted:
http://online.wsj.com/article/SB10001424052970204880404577225493025537660.html
Yes, Tax Advocates, corporations don't have to declare dividends. So just how much dividend income do you think there will be to tax when the rate jumps from 15% to 43%? Better not spend all those tax receipts on those "shovel ready" projects just yet. The market itself will also have something to say about this, and it may already be speaking to us. Shares of Johnson and Johnson (JNJ, $68) currently offer a 3.56% dividend yield, almost 100 full basis points (a full percentage point) above the yield on the 30-year Treasury. JNJ's after-tax dividend yield with the tax rate at 15% is 3.026%, but with the tax rate at 43.4% the after-tax yield is only 2%. Just maybe the market is already pricing in the very real possibility of those higher taxes on dividends. That would help explain the persistence of some dividend yields far above the rates on Treasury bonds.
As troubling as all of this is, even more disturbing is the underlying condition that enables such political posturing: a growing economic illiteracy among the electorate. As a consequence, our "culture of ownership" is rapidly being replaced by a "culture of entitlement." Part of what holds our economic well-being together is a grand equilibrium of sorts--a tension, actually--between those forces who seek to grow our economic pie and those who aim to redistribute the pieces of the existing pie. The pie will not grow without private investment capital, because government can create jobs but government cannot create wealth.What the Tax Advocates fail to appreciate is that too many whacks with the serving knife will actually make the pie smaller. Scarier still is the attitude among some on the extreme left that we would be better off if everyone with a positive net worth were taken down a few notches on the economic ladder instead of having a society where some are more affluent than others. The dynamism of the private sector is the proverbial goose that lays golden eggs to finance public expenditure in this grand equilibrium, and now it is open season on the goose. The Tax Advocates are locked and loaded.
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of JNJ. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.
