Jewish World Review May 15, 2003 / 13 Iyar 5763

Paul Greenberg

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Consumer Reports

The great tax debate, or: politics vs. economics | A tired worker comes home from the plant, and between fixing supper and seeing to the kids and putting the bills aside for later, she tries to be a good citizen and catch up on the day's news. The headlines are about tax cuts and an argument over them in Washington, but she figures the politicians will reach their usual compromise. They always do.

It'd be nice to keep some more of her paycheck, and she may even wonder what the talk about not taxing corporate dividends would mean for her 401(K), but that's about the end of it. She's too busy doing real work -- holding down a job, raising a family, volunteering -- to spend much time following the ins and outs of tax legislation. Anyway, the final bill will come with loopholes galore for special interests, many of which won't be discovered for months, if ever. That much she knows.

Meanwhile, the debate in Congress slogs on through committee hearings, floor votes, separate but equally partisan speeches, and lots and lots of great big numbers. At last report, the House of Representatives had passed a 10-year, $550 billion tax cut by a party-line vote of 222 to 203. Which is $176 million less than the cut the president had first proposed.

Nor does the House bill completely adopt the centerpiece of the president's original plan -- a proposal to end the double taxation of corporate profits. Now the government taxes both the corporation when the profit is made and then the shareholder when it's passed on in the form of dividends. If this bill passes, the top tax rate on both dividends and capital gains would drop to the same 15 percent.

Meanwhile, back in the Senate, the Finance Committee has voted out a more modest proposal, making only the first $500 in dividends exempt from taxes. Above that, a total of 20 percent of dividend income would become tax-free after five years. The capital gains tax wouldn't be cut at all.

To add to the general confusion, the Senate bill had the wrong number on it, and it'll require another vote in committee to straighten out the clerical error, which means the debate in the Senate may be delayed for days, or maybe a week. It's as if the bountiful confusion already in the tax code were contagious, infecting every attempt to change it.

But what difference will it all make -- besides giving Republicans and Democrats another reason to call each other names? ("Anti-growth!" "Trickle-down economics!") To listen to the commentators, you'd think the only thing that mattered about this debate over taxes is the maneuvering for next year's elections.

Actually there's an important difference between the president's plan and the opposition's. By eliminating the individual income tax on dividends, the administration would discourage the kind of speculative boom that marked the American economy in the '90s (followed by the predictable bust) and restore a measure of reality to economic decision-making. How? As a businessman friend explained it to me:

"Years ago, dividend income was much more important to investors and therefore to the companies that wanted to attract them. But by the 1990s, many companies realized there was another way to reward shareholders other than paying dividends, and that was to use the same amount of money that might have gone for dividends to purchase company stock and then retire it. That way, there would be fewer shares outstanding, which would increase earnings per share, and so drive up the value of their stock -- since stock is traded as a multiple of earnings. Shareholders were rewarded with higher stock prices, and when they sold the stock, they paid only a 20 percent capital gains tax instead of the close to 40 percent they'd have to pay on dividend income, or almost double the capital gains tax. Which suited management just fine, since it could devise stock option plans and, as the value of the stock went up, management would benefit, too.

"The upshot is that, even if a company made the same profit every year, the stock would go up if management used some of the corporation's cash flow or other funds to retire stocks. So you had the anomaly of management being rewarded just by retiring shares -- not by increasing the overall profit and productivity of the company."

And that's just one of the ways in which the country's vague and almost incomprehensible tax code (now at 45,662 pages and about to be expanded again) distorts economic decision-making.

Economic sense is the first casualty when the issue of taxing dividends becomes just a political football. The Senate's approach lacks the basic appeal to justice of the president's case against double taxation. Nor does it give corporations and investors enough of an incentive to concentrate on increasing profits, creating jobs and generally growing -- instead of just inflating the value of their stock.

The president's plan promises to change corporate governance and decision-making in basic -- and wholesome -- ways. It could also change the way investors choose to invest -- on the basis of dividend income rather than stock appreciation. Both would be changes for the decidedly better. In short, this president means business in more ways than one.

But all of this may be just so much static to the citizen who's got more pressing matters to attend to this morning, like getting the kids off to school. When democracy was in its infancy, a sage observer said the future would now belong to the people -- or rather to those who could explain things simply to them. What's needed in this debate is someone who can do just that, and demystify the whole, tangled issue.

A couple of hundred years ago, the French had just such an explainer in Frederic Bastiat, author of "Economic Sophisms." In perhaps his most famous essay, "What Is Seen and What Is Not Seen," he begins by repeating the offhand, unthinking comment of a bystander who sees a shop window broken. Ah, well, says the bystander, at least it will make business for the glazier.

But M. Bastiat points out that one should consider not only the effect of the money spent to repair the damage, but what other, more productive uses that money could have been put to.

If some halfway compromise is reached on this proposed tax cut, the result may not be bad, but neither will it represent a dramatic, long-term turnaround for an economy that's still basically marking time. Think of what won't happen if dividends remain heavily taxed: Investing in stocks won't be nearly as attractive over the long term, corporations will continue to concentrate on ways to manipulate the value of their stock rather than produce dividends, and the economy will fail to thrive.

Yes, the people would get another middling tax cut, but the economy won't get the long-term redirection it needs. A basically political decision will have been made, not an economic one.

The late Henry Hazlitt, who came as close to being our own Frederic Bastiat as anyone could, put it this way: The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups. Which is really the best argument for eliminating double taxation, and inducing both companies and investors to value dividends again. For healthy dividends are about the surest sign of a healthy economy -- an economy that benefits not just this or that interest, but all of us.

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JWR contributor Paul Greenberg, editorial page editor of the Arkansas Democrat-Gazette, has won the Pulitzer Prize for editorial writing. Send your comments by clicking here.

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