Offset Corporate Tax Cuts With Hikes for Investors

Higher rates on dividends and capital gains would discourage short-termism and promote business investment.

Scissors photos work well when the topic is tax cuts.

Photographer: Ethan Miller/Getty Images

I recently wrote that the U.S. should reduce the corporate income tax, and replace the lost revenue with personal income taxes. But there are two other revenue sources that could substitute as well -- capital gains and dividend taxes.

The goal of tax reform should be to increase business investment, which the U.S. needs more of:

Less Building for the Future

Business investment as a share of GDP

Source: Federal Reserve Bank of St. Louis

Economists often talk about capital gains taxes, dividend tax and corporate income tax as if they are essentially the same thing -- taxes on capital. And for someone considering investing in stocks, they are indeed fairly similar. Suppose I have $1,000 that I’m contemplating investing in Wal-Mart stock. If I do, I’ll have a claim on Wal-Mart’s future earnings. Corporate income taxes take away some of those earnings and gives them to the government. If Wal-Mart tries to hand its earnings over to me by issuing a dividend, then dividend taxes take away some of that money. And if Wal-Mart tries to give me its earnings by buying back its stock and raising the share price, capital gains taxes confiscate some of that. (Stock buybacks and dividends have a few differences, but both represent ways of returning money to shareholders.)

So if I’m thinking ahead about my potential Wal-Mart stock purchase, these are just three ways that the government will take some of the value of my investment. Each of these taxes gives me an incentive to skip the stock purchase, and put my money in a bank account, or use it to consume more. If the taxes got too high, it could starve companies of the financial capital they need to expand and hire more workers, and the economy could suffer. What’s more, the taxes add to each other -- corporate earnings are taxed once at the time they are earned, and a second time when they are handed out as capital gains from stock buybacks or dividends. This is known as double taxation. For these reasons, some tax economists recommend reducing or even eliminating taxes on capital gains and dividends.

But there’s a big, important difference between the types of capital taxes. Suppose that instead of a prospective Wal-Mart stock buyer, I’m someone who already owns the shares. Now, the taxes affect my calculus in different ways. If I use my voting power to encourage Wal-Mart to hand over its earnings in the form of dividends or buybacks, I pay the dividend and capital gains tax immediately. But if I encourage Wal-Mart to re-invest its profits -- building new stores, buying new equipment and hiring more workers -- I pay the corporate tax when the income is earned, and the capital gains or dividend tax sometime in the future when the company decides to hand me back my money.

In other words, for existing stockholders, the corporate income tax is an incentive to take money out of a business and spend it instead of reinvesting it, while capital gains and dividend taxes are a reason to delay taking money out. If the goal of tax policy is to make businesses invest more, then corporate taxes are definitely bad, but capital gains and dividend taxes are ambiguous.

In the real world, dividend tax cuts haven’t done a very good job at prompting businesses to expand. In 2003 the U.S. enacted a huge cut in dividend taxes, called the Jobs and Growth Tax Relief Reconciliation Act of 2003. The top dividend income tax rate went from 38.6 percent to 15 percent. Dividend issuance increased somewhat. But as a 2015 paper by economist Danny Yagan found, this gigantic tax cut did nothing to stimulate business investment. Another recent study in Sweden also found no effect.

Contrast this with the evidence on corporate income taxes. A number of studies have found that cutting the corporate tax does boost business investment. This fits with intuition -- corporate taxes clearly discourage business expansion, while the case for cutting capital gains and dividend taxes is unclear.

This suggests that if the U.S. wants to get businesses to expand more, instead of just disgorging their cash, it should consider shifting away from the corporate income tax to capital gains and dividend taxes.

There might be another reason to raise the capital gains and dividend taxes: discouraging corporate short-termism. Many industry leaders worry that financial markets focus too much on annual stock performance, forcing public companies to spend too much energy on meeting quarter-to-quarter earnings forecasts. Capital gains taxes, by encouraging investors to keep their money in a company, could blunt short-termism and lead to more investment for the long term. This idea isn’t without risks. Locking in investments could discourage investors from moving their money from old, slow-growing companies to fast-growing young ones. But with corporate borrowing rates near 50-year lows, this doesn’t seem like that big of a danger right now.

So the U.S. should consider shifting the type of taxes it employs. Higher levies on capital gains and dividends, coupled with lower taxes on corporate earnings, could encourage the kind of future-oriented business expansion that the country needs.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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    Noah Smith at

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