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Tax Those Dividends

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If you follow the stock market, you'll notice that big public companies are paying out all sorts of special dividends early to avoid a dreaded tax hike on such earnings. If the Bush tax cuts lapse, the top dividend tax rate will rise from 15 percent today to 39.6 percent on January 1. Or, if President Obama gets his way, dividend tax rates will go up only for the top 2 percent of earners, while remaining unchanged for everyone else.

In other words, dividends may once more be taxed as regular income -- and that's how it should be.

Thanks to the 2003 tax cuts enacted under President Bush, dividend tax rates are now extremely low. They were higher in both the 1980s and the 1990s. Extremely affluent households have been the main winners from that 2003 tax cut because the wealthy own the vast majority of all stock. It's been estimated that in 2012, the top 1 percent of households will receive a stunning 71 percent of all capital gains. What's more, because dividends paid on stocks in 401(k)s are not taxed (they are reinvested), more ordinary Americans who own modest amounts of stock saw virtually no benefit from the cut to dividend taxes enacted by Bush.

Rarely has any tax cut cut in history shoveled more money to wealthy households than the 2003 tax cut for both dividends and capital gains. That law -- along with a previous tax cut for capital gains in 1997 -- is a big reason that tax rates on the very richest Americans have declined in the past 20 years. As the Center for Budget and Policy Priorities has noted:

The top 400 households paid 16.6 percent of their income in federal individual income taxes in 2007, down from 30 percent in 1995. This decline works out to a tax cut of $46 million per filer in 2007, or a total of $18 billion in tax cuts for these households per year.

According to the Congressional Research Service "changes in capital gains and dividends were the largest contributor to the increase in the overall income inequality," between 1996 and 2006. In other words, even as inequality is routinely depicted as some inevitable and unavoidable economic fact of life, it turns out that the biggest driver of inequality in recent times have been intentional changes in tax policy.

Proponents of keeping taxes on dividends low make several arguments, none of which hold up under scrutiny. First, they routinely say that average retirees and 401(k) holders would be slammed by any increase in dividend rates -- as CNBC's reporter Jeff Cox claimed yesterday in a segment I was on. (Watch it here.) As noted earlier, though, 401(k) income isn't touched by these higher taxes and, overall, most Americans don't receive taxable dividends.

Second, they say the overall stock market and economy would suffer from raising taxes on dividends. But that doesn't square with the historical record. A big hike in dividend tax rates in 1993 was followed by one of the strongest economies and bull markets in U.S. history -- while the dividend tax cut in 2003 didn't turn around a generally sluggish decade for both the economy and stock market. Overall, it's not clear that dividend tax rates make much of a difference.

Third, opponents of dividend taxes say it comprises a form of "double taxation," since corporate profits are taxed before dividends are paid. Of course, though, many corporations pay a low effective tax rate -- or no taxes at all -- and the result of getting rid of such "double taxation" would be to allow those who live off their dividends, such as wealthy heirs, to basically pay no taxes on their income at all.

Still, it is true that taxing productive economic activities such as work and wealth creation is bad policy. Many OECD countries have lower taxes on capital gains and dividends, and instead rely more on taxing consumption and energy. They tax bad behavior, not good behavior.

I'd be all for a discussion of lowering taxes on wealth and work and raising taxes on polluting and consuming, assuming this can be done in a progressive fashion. Good proposals are out there along these lines. But as long as we are mainly taxing wealth and work, we should do so equitably.

One last point: Obama's proposed hike in dividend taxes on the wealthy will raise over $200 billion for deficit reduction over the next decade. If we don't bring in this revenue here, it will have to come from somewhere else.