Capital: U.S. Tax-Cut Plans Risk Opening Doors For Shelter Schemes

By David Wessel
819 words
22 May 2003
The Asian Wall Street Journal
A2
English
(Copyright (c) 2003, Dow Jones & Company, Inc.)

CONGRESS CALLS the U.S. tax bill it is considering the Jobs and Growth Tax Act of 2003, but it's at risk of passing the Great Tax Shelter Act instead.

President George W. Bush's plan to eliminate the tax on dividends rests on a couple of respectable principles: The tax code shouldn't push U.S. companies to rely more on borrowing and less on selling shares of stock to raise money. And if government wants more of something (in this instance, more saving and investment) it ought to tax it less.

Turning those principles into policy proved troublesome from the start.

The best way to change corporate behavior would be to change the taxes companies -- not shareholders -- pay, perhaps by letting businesses deduct dividend payments the same way they deduct interest payments. But after Enron Corp., no politician wanted to sell a corporate tax cut. Roughly half of all dividends go to shareholders that don't pay U.S. income taxes, such as college endowments, pension plans and foreigners. Those profits aren't taxed twice (once when earned by the company, once when paid to shareholders as dividends).

When the White House asked the Treasury Department to turn a slogan -- "end the double taxation of dividends" -- into tax policy, the Treasury dusted off a plan crafted in the waning days of the administration of Mr. Bush's father, President George H. W. Bush. It quickly dropped the original plan's out-of-favor notion of cutting some taxes and raising others to avoid enlarging the budget deficit.

"Since 1997, politicians haven't been willing to make anybody pay for anything -- war, tax cuts, health care, the farm bill," says Gene Steuerle, an Urban Institute economist who worked in the Reagan Treasury.

THE TREASURY DID attach complex provisions designed to make sure companies paid taxes on profits before turning them into dividends. After all, according to Massachusetts Institute of Technology economist George Plesko's estimates, roughly one-third of all dividends are paid from profits on which corporate taxes have never been paid -- either because companies took advantage of tax breaks created by Congress to encourage, for example, investments in research or housing for poor people, or because companies exploited unintended tax loopholes.

Lobbied hard by those who sell and use corporate tax breaks, Congress ignored Treasury's advice. The House opted for a mercifully simple cut in the top tax rate on dividends to 15% from 38.6%. The Senate decided on a temporary elimination of the dividend tax and threw in assorted provisions aimed at curbing corporate tax abuse. But it skipped the Treasury provisions designed to make sure profits are taxed at least once.

It isn't yet clear what compromise will emerge in Congress. The Treasury says quietly it would like to add back its original language to be sure the bill delivers on what it describes as "the president's principle that the government tax dividends once and only once."

BUT THE TREASURY isn't lobbying hard on this point, and the White House rarely mentions it. "It's a classic case of the symbols coming to dominate the policy," Mr. Steuerle says. "There is a lot of pressure so the administration can claim a symbolic victory, but when the symbolism leads to an abandonment of principles, you've got a problem."

The problem sounds technical, but it has big-money consequences; the Treasury estimates them at more than $35 billion over 10 years. That's before tax-shelter experts go to work.

The capacity of companies and rich investors to exploit, and sometimes create, tax loopholes appears almost unbounded. Taxing one kind of income a lot more than another creates incentives for tax games. Eliminating or sharply reducing the tax on dividends, without making sure companies pay taxes, offers all sorts of opportunities to those who avoid taxes.

"To the extent that you can pay tax-free dividends out of profits that have never been taxed, then it's `Katy, bar the door' on tax shelters," says Michael Graetz, a Yale University Law School professor who helped devise the Treasury tax plan during the first Bush presidency.

Unless the Treasury can write some air-tight rules, a rich investor might, for instance, borrow money and deduct interest payments (against taxable investment income) on his own tax return, then use the money to buy shares of stock on which he would earn a tax-free dividend paid from profits that have never been taxed. Bottom line: The profits are never taxed, not even once, and the economy gets no new capital or savings because the investor borrows the money that he uses to buy the shares.

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