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Volume III, Number 16: 21 May 2003

Upper Class Welfare

Tim Francis-Wright

The rich are different than you and me: they get the government to do their bidding. The latest tax cut proposals in the United States House and Senate demonstrate just how different they are. In the face of rising unemployment, a stagnant economy, and fiscal crises in dozens of states, the Republican Party has devised tax cut plans that show its true colors. The centerpieces of its plans will do next to nothing to help the economy, but will amply reward the investor class, Americans who live off their investments, to the detriment of anyone who has to work for a living. Radical tax cuts on dividend income are well nigh useless for their stated purposes, boosting the economy or creating jobs, but they serve the real purposes of the Republican party very well.

The vast majority of Democratic legislators have stubbornly resisted the worst of Republican proposals. President Bush has given up on his original $750 billion tax cut, thanks to a consistent Democratic party line in the Senate. But even a fully united Democratic Party needs at least two Republican votes to be assured of a majority, so the tax cut plans now under consideration are designed to appeal to the most moderate of Republicans, those who want merely a huge tax cut instead of a massive one.

The Senate tax cut package would ostensibly cost the government $350 billion over the next ten years, but a "sunset" provision on the elimination of taxes on stock dividends received by individuals reinstates those taxes in 2007. Similar sunset provisions in both the House and Senate plans dramatically understate the true cost of the overall tax cuts, if Congress later refuses to keep the temporary tax cuts temporary. The 2001 tax cut contained a similar provision that eliminates all of its income tax and estate tax cuts, in full, in 2011. The Republicans have already tried to get rid of the 2001 sunset provisions, and would surely try to eliminate the 2003 sunset provisions as well, to double the impact of the Senate tax cut package. The latest version of the House package calls for reductions on tax rates for both dividends and capital gains to 15 percent through 2009, after which another sunset provision would reinstate the rates now in force.

President Bush and his allies in Congress have claimed for months that eliminating taxes on dividend income will help the economy and create jobs. Using tax cuts to stimulate the economy can work, if the reduced taxes translate efficiently into more spending. For example, the provision in the Senate tax cut that expands the 10% tax bracket will reduce the tax burden on the working poor, who are most likely to spend the extra money. But it is hard to see how cutting taxes on either dividends of capital gains serves either purpose. Encouraging companies to pay dividends is rewarding them for not investing profits into new equipment, employees, and the like. But stockholders by definition have disposable income that they have chosen to invest, not spend.

Rewarding investments in the stock market is hardly the most direct way to stimulate the economy. But even as a stimulant for the stock market, a tax cut for dividend income is hardly a panacea. First, a dividend tax cut will skew the current stock market by encouraging investors to pay more for shares of dividend-paying stocks. Among the stocks that will be hurt are the stocks in sectors like electronics, computing, and biotechnology—the companies that fueled the most recent period of robust growth in the American economy. Second, the way that millions of Amercians own stock is through retirement plans. None of the suggested tax cuts for dividends provides an iota of tax relief for 401(k) or other retirement accounts; when beneficiaries withdraw dividend income from these accounts, they ill enjoy no tax break whatsoever.

The proposed tax cuts would have some particularly gruesome side effects. The Senate version would provide a 50% reduction in taxes for dividends in 2003, but a full deduction in 2004 through 2006. These provisions would not encourage companies to pay dividends in 2003; to the contrary, rational actors would hold onto the cash until 2004 when it is more valuable to the shareholders. While the Senate Republican plan could have encouraged companies to spend money in 2003, or at least give it to stockholders to spend in 2003, it will encourage them to do nothing with it until 2004. Furthermore, the sunset provisions in both the House and Senate plans will mitigate the one true effect of the tax cut, on stock prices of dividend-paying stock. If a company's stock dividends are tax-free for only a short period of time, then its stock is not worth much more than a company whose dividends are always taxed. Even a sunset provision that extends until 2009 rewards companies for short-term results, not long-term stability or growth. In sum, the proposals for cutting taxes on dividends are a mess. The reason that they exist is not what they do for the economy but whom they benefit.

The Internal Revenue Service (IRS) figures from income tax returns for 2000 show who reports dividend income. Out of some 129 million individual tax returns, just over 34 million had any dividend income. In total, individuals reported some $147 billion of dividend income. The 6% of taxpayers with over $100,000 of adjusted gross income reported 43.6% of all income but 63.0% of all dividend income, and the 2% of taxpayers with over $200,000 of adjusted gross income reported 26.7% of all income but 44.7% of all dividend income. (The IRS does not separate stock dividends from money market fund dividends, which would not benefit from the reduced rates. The current stretch of very low rates on money market funds will reduce the impact of money market funds on overall dividends, so the IRS statistics that appear sometime in 2006 will tell exactly who benefitted from the 2003 tax cuts.)

Dividends are nonetheless a form of income that skews to the wealthy, albeit not as much as capital gains skew to the wealthy. The statistics do not show how dividends affect retirement accounts like 401(k) plans and Individual Retirement Accounts, both important to many middle-class workers. Making stock dividends tax-free is just the latest in a set of actions by the Republican Party that show just where its interests lie—with Americans representing the gamut from fabulously wealthy to merely comfortably affluent. While the treatment of dividend income has received a lot of attention in the press, both the House and Senate bill provide for immediate cuts in tax rates for upper-income taxpayers, with the biggest cuts going to, the richest 1% of all taxpayers. If you earn a lot of money, then the Republicans have done you a favor. If you invest a lot of money, then the Republicans have done you a big favor. President Bush and his party will trumpet the savings of the dividend tax cut for the "average" American, but the statistics show who the real winners are.

Dissenters within the Republican party, like Senator Olympia Snowe from Maine, liked the idea of a dividend tax cut aimed at small investors. Her plan, which passed the Senate Finance Committee but failed on the Senate floor, would have made the first $500 of dividend income exempt from taxes, then allowed another 10% to 20% of any further dividends to be exempt as well. The advantage of this plan is that it would not have been a windfall for the manor-house set. Even $500 of dividend income, of course, represents some serious investments. At a 2.5% pay rate, $500 of annual dividend income represents $20,000 in stock market holdings. Relatively few Americans have that much sitting in taxable accounts: most taxpayers have no dividend income in the first place.

Worse yet, the latest House version of the bill rewards most of the rewards from stock speculation, whether dividends or long-term capital gains, with deep tax cuts. The vast majority of funds in the stock market do not fund busines expansion; they flow from shareholder to shareholder, each in turn making a bet on the value of the underlying stock. Republicans like to portray the stock markets as business incubators. Most stocks on the national exchanges, however, have stopped raising money by issuing stock. Stock market traders are hardly venture capitalists; they have much more in common with gamblers in casinos. Rewarding this one type of gambling with tax breaks for the winners is more than a bit bizarre.

Cutting taxes on dividends and capital gains as much as possible is part of a Republican strategy on taxes that has two important components.

  1. Run deficits so high that the federal government will never recover.
  2. Make income taxes a sucker's game that only workers play.

Deficits today, deficits tomorrow, deficits forever

Running budget deficits in economic leans times is both proper and desirable. hether the government spends more money or reduces taxes, as long as the net cash outflow from the government enters the economy, the budget deficit will mitigate he economic slowdown or recession. What is particularly aggravating about tax cuts for investors during lean times is that the savings go to investors, not spenders. By contrast, the Senate refused to include a provision in its tax cut bill to extended unemployment benefits to Americans whose benefits will expire at the end of May. If the unemployed will not spend a government check, then no one will.

The Republican Party probably still has some true believers in trickle-down economics, the option that large tax cuts for the rich will create a cascade of cash flows down to the lower reaches of economic society. The party line in the Reagan White House was that his 1982 tax cut would nonetheless send the federal budget into surplus as taxable income increased. The thinking after the Reagan presidency was that rich taxpayers invested the money they saved and the lower classes got very little of the largesse. The Republican Party certainly does have a few remaining fiscal conservatives, politicians who love lower taxes and small government but who loathe deficit spending even more. But the majority of the politicians in today's Republican Party want to create huge budget deficits for their effect on future presidential administrations.

An unchecked stream of large budget deficits is exactly what Republicans want. Future Democratic administrations will face a series of hurdles. First, they will have to pay interest on an increased load of debt. Second, if the Republicans are lucky, then long-term interest rates will start an upward trend, so as time goes by, the problem gets worse. Third, reducing the public debt entails finding the revenue to pay down that debt. That revenue could come from new or increased taxes, or by cutting governmental spending. Republicans will leave the former option to the Democrats, but keep the second option for themselves. Of course, if the economy outgrows the public debt, then deficits post no threat, but the current administration has no peer in finding ways to aggravate budget deficits.

Republsicans learned to appreciate that the increasing public debt of the presidencies of Reagan and Bush the Elder was a very real constraint on Democratic policies during the Clinton presidency. Despite the Republican claim to "fiscal conservatism," it was Bill Clinton who really acted as a fiscal conservative. A tax increase on wealthy individuals and a booming stock market allowed Clinton to post budget surpluses at the end of his second term: what Reagan and Bush took 12 years to create, Clinton took only 6 to destroy.

Income taxes: no thanks, I'm rich

Cutting taxes on dividends is just one of several recent moves by Bush and the Republican Party to eliminate all taxation on investments. One possible component of the 2003 tax bill is a cut in capital gains taxes (the House bill has a maximum rate of 15% on any capital gain). Capital gains skew enormously with income. In 2000, taxpayers with over $1,000,000 of annual gross income—annual income, not net worth—reported fully half of all capital gains. Any cut in capital gains taxes is really a tax cut for the very rich.

Current law has already expanded the limits on tax-advantaged retirement savings accounts. The maximum contributions for Individual Retirement Accounts (IRAs) will grow in stages from $2,000 to $5,000 per year; the maximum for 401(k) plans will grow in stages to $15,000 per year. The only workers who benefit from these provisions are affluent ones who have enough disposable income to sock an extra few thousands of dollars each year into these accounts. Low-income workers do not make enough money to come close to the current 401(k) limits and rarely have the ability to put more than $2,000 per year into an IRA account. Raising the annual upper limit for these accounts by several thousands of dollars

Several months ago, when the Treasury Department first floated ideas about eliminating taxes on dividends, it also floated ideas about personal savings accounts that would greatly benefit rich taxpayers. The Department proposed replacing IRA accounts with two types of savings accounts, one for retirement and one for any purpose, with annual contribution limits of $7,500 per account per person per year. Contributions would be tax-exempt, but earnings from the accounts would be tax-exempt forever. This treatment is similar to the current treatment of Roth IRA accounts, which have high but finite income limits for participation. The proposals would be all but worthless to most working Americans, who seldom have enough disposable income to make investing an option at all. But they would be very valuable to the wealthy, to those with $15,000 per year of pocket money to invest.

The Republican fixation with the estate tax should showcase just who benefits from estate tax repeal: Americans with many millions of dollars in their estates. In most large estates, the assets are appreciated capital assets—stocks and real estate—that have not been taxed because they have not been sold. Repealing the estate tax eliminates all taxation on these sorts of assets. Under current law, the estate tax will suddenly disappear in 2010, then reappear in 2011. Republicans will keep trying to repeal it, permanently. For the very rich, one problem with the estate tax is that it hampers their abilities to create an aristocracy. Without an estate tax, millions of dollars could be given to a "dynasty trust" set up in South Dakota or Florida; the dynasty trust can live for generations and set up myriad descendents for lives unsullied by the need for gainful employment.

The key Republican tax proposals during the Bush administration have amounted to massive amounts of welfare for a class of Americans who don't need the help. It is hardly class warfare for Democrats to oppose huge tax cuts that skew to the wealthiest Americans. A class war is indeed brewing in the halls of Congress, a war of the would-be aristocracy against everyone else. The Republicans, servants of the upper class, are the revolutionaries who started it.