Commentary: From Good Tax Policy to Empty Gesture

By Howard Gleckman

When President Bush first pitched his ambitious tax cut in January, its centerpiece was a dramatic change in the way corporate profits would be taxed. Bush's radical idea: First require companies to pay tax on earnings, then let them distribute those profits to shareholders tax-free, either as dividends or as capital gains.

Although complex and, at a cost of $400 billion over 10 years, expensive at a time of rising budget deficits, many economists agree that the idea would make for better tax policy. It would have taxed earnings once, in contrast to today's system, in which businesses and investors often pay taxes on the same earnings. It also would have reduced tax incentives for companies to borrow, rather than using equity.

Just as important, coming after months of corporate accounting scandals, the Administration argued that its plan would discourage businesses from using gimmicks to slash their own taxes. Because shareholders would only receive a tax break if a company paid taxes on its earnings, backers of the plan argued that shareholder pressure would help trim the use of tax shelters.

As the Bush plan moves through the legislative mill, however, the rationale for the dividend tax cut is disappearing in a flurry of political dealmaking. Senate Democrats and moderate Republicans insist that any measure be held to roughly $350 billion. Since that doesn't leave enough to pay for the full dividend tax cut, Congress and the White House are struggling to cut a deal that would allow the Administration to claim victory on dividends. If that happens, the price will be worse, not better, tax policy.

The latest alternative being pushed by the White House: Phase the dividend tax cut in over three years, and let it expire after five. The scheme was being debated in the Senate on May 14. Even if it fades there, it could reemerge as central to the final tax cut. Only by assuming the plan's expiration will the scheme fit the Senate's $350 billion tax framework. That, of course, would defeat the purpose of the cuts. "They have really gone astray on the dividend tax," says Robert V. Di Clemente, chief U.S. economist at Citigroup (C ). "It's going to be butchered."

The White House and its Hill allies openly hint that they intend no such expiration to occur. If it doesn't, the scheme would cost as much as $375 billion over a decade, nearly as much as the original Bush plan. But if the phaseout remains, business and investors would have to deal with a far more uncertain and complex regime for taxing dividends.

That is exactly the opposite of what the Administration promised when it proposed ending the double taxation of dividends. Rather than make capital markets more efficient, it would make them less so. Rather than stimulating businesses to use stock sales to finance expansions -- and end their tax shelter games -- it would leave CFOs scrambling to figure aftertax returns and looking for ways to game the system. Indeed, even many conservatives who support dividend tax cuts see the latest version as deeply flawed. American Enterprise Institute economist Kevin A. Hassett dismisses it as "patently absurd." Adds one business lobbyist who embraced the original plan under heavy pressure from the White House: "This is getting ugly. I'm holding my nose here."

He's not the only one. Washington is in the midst of a bitterly partisan battle that is more about winning than about boosting the economy or creating a more effective tax system. Both corporations and individual taxpayers will come out as losers.

Gleckman covers tax policy from Washington.

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