The Dividend Tax Cut: Prepare for a Paler Version

Scaled-back alternatives are ricocheting around Washington

President George W. Bush's sweeping plan to eliminate most individual taxes on dividends and capital gains may be dead in the water, sunk by congressional deficit fears and a desire to emphasize immediate stimulus over long-range tax reform. But the White House remains committed to pushing a scaled-down version of the dividend break, insisting it would boost the stock market and the economy.

While it's clear that the President will have to accept some compromise on dividends, he's fighting for the most generous proposal he can get. That's got both lawmakers and economists scrambling for the best way to trim it.

It turns out that paring back Bush's $396 billion dividend tax break is no easy task. Every option has either economic or political liabilities. And no downsized alternative will generate the big growth payoff the White House claimed for its initial plan. As a result, the White House and Congress may be forced to refocus a dividend cut on more achievable goals -- simplifying the tax code and reducing the gap between low-tax capital gains and higher-tax dividends.

Under the original White House plan, once a company paid taxes on earnings, its profits would be tax-free to investors, whether they were paid out as dividends or capital gains. But after Congress agreed to limit any tax cut to between $350 billion and $550 billion, the White House had to retool. One idea, floated by Treasury Secretary John W. Snow: Give investors a 50% dividend tax break in 2003, increasing it gradually to 100% by 2013.

That gets a chilly reception from many economists. Because taxpayers would not see much of the benefit for years, it would provide little immediate stimulus, although it could cost as much as $300 billion. And melding a phased-in investor tax break with the requirement that companies first pay their own taxes on earnings would be a bookkeeping nightmare. "It's not easily dialed up," warns former top Bush chief economist R. Glenn Hubbard. "You're probably better off just doing a 50% exclusion" for dividends and capital gains.

Treasury officials won't say whether Snow also favors the change for capital gains. But taxing dividends and investment profits in the same way has strong support on Capitol Hill. Today, most gains are taxed at 20%, while investors pay up to 38.6% tax on dividends.

House Ways & Means Committee Chairman Bill Thomas (R-Calif.) would fix the problem by taxing most gains and dividends at the same 18% rate. That would cost about $230 billion over 10 years and give wealthy investors a big break. The biggest downside: Taxpayers would still have to fill out an agonizingly complicated Schedule D.

A simpler solution, which has drawn interest from Senate Finance Committee Chairman Charles E. Grassley (R-Iowa), would exclude an equal amount of both dividends and capital gains from tax. The plan would not only smooth out taxes on investment, it would vastly ease paperwork. "To the extent it's possible, having symmetrical treatment for gains and dividends would be beneficial," says Brookings Institution tax economist Peter R. Orszag.

But the 50% exclusion for both dividends and capital gains being mulled in Congress would cost up to $270 billion -- on top of the $335 billion in other "economic growth" tax cuts Bush has proposed. Deficit hawks could cut the price by trimming the exclusion to, say, 30%. Since that would cut taxes on dividends but raise them for capital gains, Treasury would lose little or no money. But the slimmed-down version would provide little stimulus and boost capital gains taxes for the wealthiest investors, making it anathema to the White House.

That's why others are getting behind a solution they believe will be easy for taxpayers and less expensive: letting families exempt, say, $1,000 of dividends from taxes each year. Among the backers of such a cap: leading Senate moderate John B. Breaux (D-La.). It would allow roughly 8 million families to avoid both taxes and paperwork on their dividends and reduce the tax bill for millions of others, at a cost of only about $3 billion a year. For symmetry, the first $1,000 in capital gains could be exempted as well. The downside: It would generate no economic stimulus.

Some Democrats like an idea proposed by Urban Institute economist Leonard E. Burman. He would eliminate taxes on both dividends and gains for earnings already taxed to a company, just as the Bush plan would. But gains and dividends on all other earnings would be taxed at ordinary rates of up to 38.6%. The benefit of this approach is that it would tax gains and dividends more equally. The downside: Burman's plan would raise taxes on capital gains, an idea unlikely to generate enthusiasm at the White House.

Lawmakers will almost surely pass some investor tax cut by the end of May. It won't be hard if Congress settles on a $500 billion revenue bill. But fitting it in the $350 billion version will be tougher. One solution: Lawmakers are looking to close some $50 billion in corporate tax loopholes -- a step that would make room for a bigger dividend cut.

The best hope is for a skinnier exclusion for both dividends and gains. It wouldn't provide much stimulus, but it might marginally improve the tax code. And it may help get the government out of the business of subsidizing investment decisions.

By Howard Gleckman in Washington

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