All of the maneuvering and negotiations to address the fiscal cliff aren't happening in Washington. Quite a few of them are happening on Wall Street and in board rooms across the country. The very real possibility that tax rates are going up is paying dividends - quite literally. Companies are issuing special dividends to distribute corporate funds to shareholders ahead of next year's potential tax rates.
Under current tax policy, corporate dividends are taxed the second time at a rate of 15%. It is first key to understand that corporate earnings are subject to federal income tax rates of 35%, plus state income taxes which may be as high as 16%. Dividends are not a deductible business expense. They represent the distribution of profits to shareholders after corporate taxes are paid.
In the event that no agreement on the fiscal cliff is reached, the "temporary" tax rate that has been in effect since 2003 would expire, lifting taxes on dividends up to 43.4 percent for high income individuals. That's just short of tripling the tax rate on dividends. 3.8% of this new rate is from a surtax to help pay for health care reform. You know, that last time the president "asked" that the wealthy just pay a little bit more of their "fair share."
The result of the potential tax hike is that companies are rushing to approve special dividends to be paid in December, thus avoiding next year's tax rates. Costco alone is paying $3 billion to shareholders above routine dividends. Even more peculiar, Costco and others are borrowing much of the money that will be distributed to shareholders. It is clear that these companies are paying dividends today in lieu of dividends that would have been paid tomorrow.
The result will illustrate what often happens when dramatic changes are made to the tax code. Behaviors are quickly changed to maximize the benefit of those who would pay the tax. That's basic human behavior and critical to any understanding of economics.
Tax receipts for this year, 2012, will go up because of this behavior. There are some estimates that place the potential for advance dividends paid this year to approach $200 billion. At a 15% tax rate, that would indicate that $30 billion will go to the treasury this year that otherwise would have not. So that helps the deficit, right?
Not necessarily. While 2012's numbers will be temporarily improved, it is also clear that companies will be recalculating their strategies for returning earnings to their shareholders. Companies, remember, are not required to pay dividends. We have seen that many companies are more than willing to sit on large amounts of cash in overseas subsidiaries rather than to bring that cash back home and face the 35% corporate tax rate. They are equally likely to sit on cash or buy back company stock to avoid subjecting shareholders to a 43.4% second tax on their profits.
The result, as we are likely to see, is that the tripling of tax rates on dividends will quite likely see tax collections for dividend taxes go down, not up. But, after all, much of this exercise really isn't about increasing revenues to the Treasury. The president has made it clear that this is about increasing rates, not revenue. It's about "fairness." Tax policy is being advocated not based on economics, but on elusive goals of economic equality.
The exercise being conducted by corporations and their dividend policies should serve as a reminder that our tax code is complicated and offers many different incentives, many unintended, for changes in behavior because of it. Ideally, a sound tax system should minimize these opportunities, knows as "distortions" among economists.
A broad based, low, and relatively flat tax system is preferred to get government out of the way as much as possible so consumers and businesses can make the decisions that are best for them without undue influence from the government. That is the needed message for tax reform. It's one of the many that Republicans are not yet making as part of the ongoing tax negotiations.
Charlie Harper, author and editor of the Peach Pundit blog, writes on Georgia politics and government; www.peachpundit.com.