Allow me to present an oversimplified parable to explain what is about to happen with the dividend tax.
Imagine your family is the sole stockholder of a plain so-called "C" corporation that you started in your garage. This year, you earn $10,000,000 in operating profit. Your company pays $3,500,000 in taxes. It writes a check to the IRS, leaving the business $6,500,000. Earning a profit is hard business. That is no small feat. Very few people in history will ever pull it off, at least within one generation.
On January 1st of 2013, your family calls a shareholder meeting and votes to distribute all of the remaining money as a cash dividend. You write checks for $6,500,000 and mail them to everyone based on their total percentage ownership in the firm.
So far so good?
Here is where it gets ugly.
For the past decade, the stockholders would have been forced to pay another 15% on their dividends when they received the check (possibly more depending on the state and city in which they reside). In this case, as a group, your family would have needed to send in an additional $975,000. That would have left them with $5,525,000 assuming they lived in a tax-free state like Florida or Texas. The money would have gotten split up among the stockholders and everyone could have lived on the successful family business.
Things are about to change, unless Congress and the President act. If the dividend tax structure expires at the start of 2013, you won't pay 15% as has been the case for roughly a decade. Instead, you would pay personal income tax at ordinary rates. Right now, the top ordinary rate is 35% but it is set to increase to 39.6% plus there is a new 3.8% tax to pay for the health care reform bill, bringing your tax bite to an additional 43.4%.
That's right. If things don't change, starting in 2013, your family members would have to pay an additional 43.4% tax on dividend income.
That means of the $6,500,000 that was paid out, you'd need to mail another $2,821,000 to the government. Your family would have earned $10,000,000 and been left with only $3,679,000 because you had to send a staggering $6,321,000 to the IRS to pay for a couple of stupid wars and out-of-control entitlements. You work for a lifetime and everyone else gets to take $63.21 out of every $100.00 you earn, leaving you with $36.79.
Investors Will Simply Change Their Behavior In Response to a Dividend Tax Increase
Here is where the government never ceases to amaze me. What do you think the probability of any rational person paying an adjusted 63.21% of their income is? Virtually nill.
- First, you would have a rush of families convert to either S-Corporations or limited liability companies with elected pass-through partnership taxation, removing the entire layer of corporate taxation.
- Next, you would have publicly traded corporations hold off on increases in dividend distributions, hoarding more cash. That's exactly what we need in the middle of an economic recovery, isn't it? (That's sarcasm, if you can't tell.)
- Thirdly, you'd see a significant portion of investors slowly migrate all of their dividend paying positions into accounts such as Roth IRAs, SEP-IRAs, 401(k)s, etc. They'd hold non-dividend paying stocks in taxable brokerage accounts. This technique is called asset placement.
- Fourth, you'd see a lot more use of very niche tax strategies that were only available to the rich and super-rich, leaving the burden to be paid by the small guys who are successful enough to get taxed but not successful enough to have $1,000 per hour lawyers and accountants.
- Fifth, you'd see stock prices fall. Investors want a net 3% to 4% on their money for mature blue chip stocks in today's world, factoring in inflation and Treasury yields. That isn't going to change. If the government taxes a bigger bite of the dividend check, investors are going to demand a higher yield, resulting in falling prices. Again, this is simple math. There is no way around it. In the middle of an economic recovery, once again, who, precisely, thinks it is a good idea to have stock prices fall and create a negative wealth effect? Make people feel poorer, and they spend less. The less they spend, the worse the economy. This is not rocket science.
For those of you arguing, "Yeah, but no one pays the sticker rate!" that is sort of the point, isn't it? Why do we tolerate a tax system that is so byzantine it rewards those who are able to afford to play the tax system rather than those who produce and contribute to society? If they allow the dividend tax to increase, this isn't going to end well. It will result in more games, more complex workarounds, and perhaps even greater resentment on both sides.