A Reality Check on Republican Claims About the Capital Gains and Dividend Tax Cuts

February 28, 2006
A Reality Check on Republican Claims About the Capital Gains and Dividend Tax Cuts

Experts on both ends of the political spectrum dispute Republican claims that capital gains and dividends tax cuts benefit all Americans and that the extension of these tax cuts are necessary for economic growth. The truth is, these tax cuts have had little, if any, effect on the economy so far and may harm economic growth in the long-run. Middle-class families are paying the price for these expensive, deficit-financed tax breaks for the wealthy. Instead of arguing for more tax breaks for wealthy special interests, Washington Republicans should work with Democrats to provide real tax relief for middle-class Americans.

What they say: The number of companies issuing dividends and the total value of dividend payments has dramatically increased since the passage of the dividend tax cut.

The truth: While the number of companies issuing dividend payments has increased, a recent study by the Congressional Research Service (CRS) reported that the total value of dividend payments has actually decreased since passage of the dividend tax cut. CRS found that the evidence "[D]oes not appear to support a significant response of dividend payouts to the dividend tax cut." The CRS report also notes that, "Not only did dividends grow very little, but they grew more slowly than nominal output and much more slowly than corporate profits...It does suggest that the dividend payout ratio fell, rather than rose, during that time."¹

What they say: The stock market has gone up dramatically since the passage of the dividends and capital gains tax cuts.

The truth: The stock market did rise following the passage of the dividends tax cut, but there is little evidence that this tax cut actually caused any of the observed increase in the market. Federal Reserve economists recently compared key U.S. stocks, which would benefit from the 2003 tax cuts, to other investments, which would not, and concluded, "We fail to find much, if any, imprint of the dividend tax cut news on the value of the aggregate stock market."²

CRS has corroborated the Federal Reserve analysis: "Any stock market effects represent temporary windfalls to holders of current stocks and are simply a manifestation of the income effects of the tax cuts; these wealth effects should not be considered as an additional stimulus...Recent studies finding that dividends had increased substantially have been used to argue that the tax cut induced private savings. This evidence does not appear robust..." ³

Moreover, experts at the Tax Policy Center have conducted an historical analysis and found that "[C]apital gains tax rates can increase significantly as they did following the 1986 Tax Reform Act, and have little apparent effect on the stock market. Likewise, the stock market can fluctuate even when rates remain unchanged." ⁴ Since May, 2003 (when the dividend and capital gains tax rates were reduced), the stock market has only seen 5.8 percent average annual growth. Between August, 1997 (when Congress last cut the capital gains tax rate) and May, 2003 (when the most recent cuts were enacted), the market grew by an average of only 2.2 percent per year. In contrast, during the period when neither the dividend tax rate nor the capital gains tax rate were cut (capital gains were at 28 percent and dividends were ordinary income) - between the time President Clinton took office and August, 1997 - the market experienced 31.4 percent average annual growth.

What they say: The dividend tax cut benefits all taxpayers - even those in the lowest income brackets.

The truth: Proponents of these "investor" tax cuts argue that 43 percent of all equity owners are from households earning less than $50,000. This may be true, but it surely does not tell the real story. According to Internal Revenue Service (IRS) data on the distribution of dividends, of the 92 million tax returns for individuals earning less than $50,000 in 2003 (representing 70 percent of total returns), only 15 percent filed a return with dividend income. The share of the total tax benefit given to these individuals was 7.8 percent and the average tax cut was $14. However, of the 2.6 million tax returns for individuals earning over $200,000 (representing 2 percent of total returns), over 80 percent filed a return with dividend income. The share of the total tax benefit given to these filers, was 63.1 percent and the average tax cut for this group was $3,543.

Again, using IRS data on the distribution of capital gains, of the 92 million tax returns for individuals earning less than $50,000 in 2003 (representing 70 percent of total returns), only 8 percent filed a return with capital gain income. The share of the total tax benefit given to these filers was 3.2 percent and the average tax cut for this group was $5. However, of the 2.6 million tax returns for individuals earning over $200,000 (representing 2 percent of total returns), 76 percent filed a return with capital gain income. The share of the total tax benefit given to these filers was over 80 percent and the average tax cut for this group was $4,306.

What they say: Lower tax rates on dividends have produced reforms in Corporate America by providing an incentive for managers to reinvest more efficiently and return unneeded earnings to shareholders.

The truth: Far from encouraging effective reform, it appears these cuts have induced behavior that benefits executives. One academic recently found that one-half of the rise in the proportion of firms that increased or initiated dividends can be traced to whether the executives hold stock versus stock options. He reported, "Specifically, we find that the division of an executive's holdings between stock and stock options has a substantial impact on the likelihood a firm either increased or initiated dividends in response to the reduction in the tax-cost of paying dividends."⁵ While there may be some efficiency gains due to the equalization of the capital gains and dividends rates, a rise in executive compensation seems to have been the tax cuts' main impact.

What they say: The lack of permanence of the lower tax rates on capital investments prevents the full growth effects of these cuts from being realized. The lack of permanence also adds to uncertainty in the market and in the economy.

The truth: Economists at the Federal Reserve considered whether the temporary nature of the tax cuts might be one reason they have not had much impact on stock market value, but found that companies with no dividends performed better than high-dividend companies during the period immediately following the announcement of the tax cuts and their passage.⁶

Proponents claim the extension is urgently needed to provide certainty to investors in the market. But these cuts don't even expire until January of 2009. The popular R&D tax credit expires this year and businesses have argued for years that the annual one-year extension provides no certainty for business planning and investment. Former Treasury Secretary Robert Rubin believes that the need for certainty argument is wrong. In fact, he goes further. He believes that based on his experience with financial markets, capital gains and dividends tax rate changes have zero effect on investment in plant and equipment. Former Secretary Rubin and many others argue that a much bigger concern than expiring tax provisions is the lack of realistic plans for reducing the growing federal deficits and debt, and that without a credible plan for reducing the deficits and debt, investors cannot have certainty in the market or economy.

What they say: Capital gains and dividends tax cuts lead to long-term economic growth.

The truth: The evidence today shows anything but economic growth from these tax cuts. In a macroeconomic analysis of the dividends and capital gains tax cuts, the Joint Committee on Taxation (JCT) found that the economic benefits were "eventually likely to be outweighed by the reduction in national savings due to increasing Federal government deficits."⁷ In fact, four of the five models JCT used showed a negative effect on real GDP by the next decade, while the fifth showed no impact at all. Similarly, CRS has warned that, "The long-run growth effects of the dividend proposal are likely negative and would become quite large over time if debt financed."⁸

In their historical analysis, Tax Policy Center experts found that, "Arguments that the maximum capital gains tax rate affects economic growth are even more tenuous: capital gains tax rates display no contemporaneous correlation with real GDP growth during the last 50 years."⁹

The truth: Proponents say that many investors will cash in on lower capital gains tax rates so that the tax cuts will actually pay for themselves. In fact, the Congressional Budget Office (CBO) recently found that, "[I]ncreases [in capital gain realizations] might suggest a large behavioral response to the tax rate cut - except that realizations also increased by 45 percent in 1996, before the rate cut. Thus changes in realizations are not necessarily the result of changes in taxes; other factors matter as well." The CBO also conducted an historical analysis and found that, "After examining the historical record, including that for 2004, we cannot conclude that the unexplained increase [in realizations] is attributable to the change in the capital gains tax rates." The CBO concluded that much of the volatility in capital gains realizations "seems unrelated to changes in the capital gains tax rates."¹⁰

In testimony before the House Budget Committee in 2004, Federal Reserve Chairman Alan Greenspan explained that "It is very rare and very few economists believe that you can cut taxes and you will get the same amount of revenues...When you cut taxes, you gain some revenue back. We don't know exactly what this is, but it's not small, but it's also not 70 percent or anything like that."

Greg Mankiw, former Chairman of the Bush Administration's Council of Economic Advisers, wrote in his economics textbook that there is "no credible evidence" that tax cuts pay for themselves, and that an economist who makes such a claim is a "snake oil salesman who is trying to sell a miracle cure."¹¹

More recently, Ben Bernanke, the incoming Federal Reserve Chairman, said at his confirmation hearing: "I think that generally tax cuts, if they're well designed, do increase growth and therefore do partially offset the revenue loss. But I think it's unusual for a tax cut to completely offset the revenue loss."¹²

In fact, some argue that making these tax cuts permanent would have negative effects on the economy. First, these deficit-financed tax cuts would place a burden on future generations that would outweigh any short-term benefit. Second, tax sheltering is much more tempting and perhaps easier when tax rates on investment gains are much lower than rates on ordinary income, as creative tax lawyers need only find ways to dress up ordinary income as capital income. Third, small business retirement plans might suffer - along with the retirement savings for millions of Americans of modest means - if these capital gains and dividends rates are extended or lowered even further. A recent study suggests that the "incentive to invest outside of qualified retirement plans may, over time, reduce small business owners' decisions to offer qualified retirement pension plans as they find that the costs and administrative burdens of maintaining qualified retirement plans, combined with the favorable tax treatment of capital gains and dividends, make saving in qualified retirement plans far less attractive than personal savings."¹³

1 Gravelle, Jane G., Congressional Research Service, "Dividend Tax Relief: Effects on Economic Recovery, Long-Term Growth, and the Stock Market," 2/14/05. And see: Chetty and Saez, NBER Working Paper Series, "Do Dividend Payments Respond to Taxes? Preliminary Evidence from the 2003 Dividend Tax Cut," 6/04.

2 Amromin, Gene, Harrison, Paul, Liang, Nellie and Sharpe, Steven A., FEDS Working Paper No. 2005-57, "How Did the 2003 Dividend Tax Cut Affect Stock Prices and Corporate Payout Policy?" 12/05.

3 Gravelle, Jane G., Congressional Research Service, "Dividend Tax Relief: Effects on Economic Recovery, Long-Term Growth, and the Stock Market," 2/14/05.

4 Kravitz, Tony and Burman, Leonard, Tax Policy Center, Tax Notes, "Capital Gains Tax Rates, Stock Markets, and Growth," 11/7/05.

5 Brown, Jeffrey R., Liang, Nellie and Weisbenner, Scott J., AFA 2006 Boston Meetings Paper http://ssrn.com/abstract=631182, "Executive Financial Incentives and Payout Policy: Firm Responses to the 2003 Dividend Tax Cut," 12/04.

6 Gravelle, Jane G., Congressional Research Service, "Dividend Tax Relief: Effects on Economic Recovery, Long-Term Growth, and the Stock Market," 2/14/05.

7 Joint Committee on Taxation, Congressional Record, Doc 2003-11771, "Macroeconomic Analysis of H.R. 2," 5/8/03.

8 Gravelle, Jane G., Congressional Research Service, "Dividend Tax Relief: Effects on Economic Recovery, Long-Term Growth, and the Stock Market," 2/14/05.

9 Kravitz, Tony and Burman, Leonard, Tax Policy Center, Tax Notes, "Capital Gains Tax Rates, Stock Markets, and Growth," 11/7/05.

10 CBO letter to Senate Finance Committee Chairman Charles Grassley, 2/23/06.

11 Mankiw, Gregory N., Principles of Economics, 2003.

12 Stamper, Dustin, Tax Policy Center, Tax Notes, 11/21/05.

13 Xanthopoulous, Judy and Schmitt, Mary, ASPPA Pension Education and Research Foundation, "Savings under Tax Reform: What is the Cost to Retirement Security," 5/27/05. And see: testimony of Mr. Brian Graff, Executive Director and CEO, American Society of Pension Professionals & Actuaries, Arlington, VA, before the U.S. Senate Finance Committee, 6/30/05.