A Brief History of Dividend Tax Rates

The media-induced hysteria over the so-called “fiscal cliff” at the end of 2012 panicked dividend investors due to the uncertainty that existed around future dividend tax rates. From 2003 to 2012, a majority of investors’ dividends were taxed at the same 15% rate as capital gains. While there was talk that dividends would be taxed at a higher rate than normal income (which was the case prior to the Bush tax cuts in 2003), Washington was able to come to a compromise, only slightly increasing the dividend tax rate for a portion of investors. Now that there is some tax rate clarity for dividend investors going forward, let’s take a look at the history of dividend taxes in the US and see how we got to where we are today.

The background of federal income taxes begins with the passage of the 16th Amendment to the United States Constitution on February 3, 1913. This amendment states: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

This relatively vague text has allowed Congress to impose its power to tax anything that it might consider income, which has included dividends paid by corporations to its shareholders. There has been a lot of controversy behind this interpretation; many believe that dividends should not be accounted in this income power. This argument will be discussed later.

In the beginning of income tax history, dividends paid to shareholders were exempt from taxation from the passage of the 16th Amendment in 1913 to 1953, except for a four year period from 1936 to 1939 where dividends were taxed at an individual’s income tax rate (when the top income tax rate was 79%). Though there were these periods of tax exempt dividends, it has been the case for the past 60 years that dividends have been taxed at various rates. Beginning with the Internal Revenue Code of 1954, dividends started to be fully taxed with only the first $50 earned exempt from taxation. For the next 30 years this policy was in place with the only variable being the initial amount exempt from taxes.

Starting in 1985, dividends would begin an 18-year period of being fully taxed at an individual’s income tax rate (the highest rate varied from 28% to 50% over this period). Then in 2003 the Bush tax cuts came into effect, thus lowering qualified dividend tax rates to 15%. Now that these Bush era tax rates have expired, it has ushered in slight changes to an individual’s dividend tax rates.

For the most part, the American Taxpayer Relief Act of 2012 (aka The Fiscal Cliff Deal) did not change dividend and capital gains tax rates. The deal only adjusted dividend tax rates for individuals earnings over $400,000 and households earning over $450,000. Now, qualified dividends for investors with incomes over those figures will be taxed at a 20% rate (same goes for capital gains tax rates).

Unqualified dividends, on the other hand, are still taxed as ordinary income (click here for more on qualified and unqualified dividends). This should bring relief to many dividend investors; many in Washington wanted to go back to the previous fully taxable policy that was in place prior to Bush tax cuts in 2003 (which would have made the highest tax rate 39.6%). Regardless, even though there was a slight bump to dividend tax rates for some, it isn’t nearly as bad as the alternative. This will allow dividend investors to continue seeing attractive returns in the near future.

Now that we have laid out a bit of the history of dividend tax rates, let’s address the controversy behind the reason for taxing dividends.

Many in the camp against the federal government’s taxation of dividends believe that taxing dividends is a sort of “double taxation.” This is because the money that is used to pay out the dividends is the profits earned by corporations. Since companies are already taxed on its profits at the corporate tax rate, this means that the shareholders, as owners, have already been taxed as well. By taxing the dividend payments, it is, arguably, taxing earnings a second time.

Because of this perceived “double taxation,” dividend taxes give corporations less of an incentive to distribute these payments to shareholders, especially if the dividend tax rates exceed corporate and capital gains tax rates. Rather, these corporations would rather limit the taxation on their profits to just the corporate tax rate (which sometimes is very small due to a number of tax deductions, exemptions and other loopholes). Instead of distributing profits to shareholders, the companies would rather reinvest in the company in order to grow the company and help boost share price, thus increasing share appreciation and capital gains. This might seem like an ideal plan for the corporation and investors. However, many times companies will make poor and reckless investment decisions that end up negatively affecting the company and share price.

Another likely scenario is that rather than distribute dividends or even reinvest in its business, corporations would prefer to just retain earnings altogether. This could end up freezing capital, hurting the business and the overall economy as the private sector fails to invest, innovate and grow.

Some experts also believe high dividend taxes cause corporations to rely too much on debt rather than financing with equity. This is because debt finance is often tax-deductible, which gives corporations an incentive to borrow in order to leverage the growth rate of profits and capital gains all while reducing taxable income. Debt financing can be extremely risky, leading to volatile earnings and stock prices and increasing the possibility of bankruptcy especially in tough economic times.

So while opponents against dividend taxes would like to see them abolished altogether to avoid the scenarios above, pragmatic insiders know that this will probably never happen. Therefore, those against dividend taxes would like to see them as low as possible in order to minimize the negative effects of this “excessive” tax on corporate profits.

On the other hand, proponents of increased dividend taxes scoff at the idea that investors and corporations are suffering from double taxation. These theorists point out that most workers are taxed more than once, and are therefore also at the mercy of “double taxation,” as they pay income taxes on their initial wages and then again on sales tax when consuming goods and services.

More over, proponents of higher dividend, corporate and capital gains taxes note that when discussing taxation it isn’t about how often one is taxed, but how much an individual or company pays in taxes. By eliminating or reducing these taxes, which tend to favor the very small percentage of the population and even investors, it ends up resulting in an inequitable distribution of taxes. Some sources have calculated that cutting dividend taxes could give the wealthiest 1% of taxpayers 42% of the benefits, while the wealthiest 10% would see 75% of the benefit.

Another argument for dividend taxes is that the income seen from dividends is unearned, and from a social policy standpoint it would be unfair to tax unearned income at a lower rate than income generated through active work. Again, this argument has a view that reducing or eliminating dividend taxes would favor the wealthy (the 1% if you will). Now some will argue that many middle class investors rely on dividends as a part of their 401(k) retirement plans and that raising taxes on dividends would negatively impact them. However, higher dividend tax proponents point out that these dividends are usually invested in tax-exempt accounts, therefore they would not be affected by an increase in dividend taxes.

Lastly, the “double taxation” argument that dividend tax opponents bring up fails to see the point that corporations and shareholders are really separate entities, even though shareholders are considered owners. Dividend tax proponents point out that corporations are a legal entity that can own property, be sued and enter into contracts in a way that shareholders cannot. This makes the corporation an actual separate entity and thus separate from the shareholder owner. So even though the corporate profits are taxed twice, dividend taxes can be seen as a sort of protection fee that shareholders pay so they cannot be sued or held liable for its corporation’s actions.

Those arguing for dividend taxes, and higher dividend tax rates, see dividend taxation as a fair progressive taxation that helps create a more equitable society on the whole. By increasing dividend tax rates, it could help raise the revenues to fight off the pesky deficit spending and large debt that so many are worried about.

Overall, historical data shows that higher dividend rates have not hurt market performance. Even though a lower dividend tax rate would benefit investors, it does not mean that a higher tax would bring down the financial markets and the overall economy with it. Actually, data shows that even during times of higher dividend tax rates, dividend stocks have outperformed non-dividend paying stocks. Many analysts point out that prior to the 2003 “Bush-era tax cuts,” dividends were taxed at a higher rate than the capital gains rate; they were taxed at an individual investor’s income tax rate. This did not prevent dividend stocks from appreciating or continuing dividend payouts at attractive yields. From 1979 to 2002, right before the Bush dividend and capital-gains tax rates took effect, dividend stocks still outperformed non-dividend paying stocks, gaining +14.4% annually compared to +11.3%.

However, the low 15% dividend and capital gains tax rate that Bush passed in 2003 did positively impact dividend investors. During this period, more and more corporations started to pay out dividends to its shareholders, resulting in attractive dividend yields and overall returns. Even so, the average dividend yield for companies in the Dow Jones Industrial average rose from just over 2% in 2003 to just under 4% as of 2012.

This data goes on to show investors that regardless of what dividend taxes are, investing intelligently in the right companies can result in attractive returns, whether it is through share appreciation or enticing dividend yields. Now that investors do have some certainty of the current tax rates, it can mean careful planning to build wealth as time goes on.

The dividend tax rate discussion is a contentious one. It can lead to very polarized, very partisan arguments in board rooms, at think tanks and in Washington. However, from an individual investor’s point of view, just know that regardless of what dividend tax rates are, attractive returns can be realized. Though there is some clarity to the short-term future of dividend tax rates, it is pretty much a guarantee that this will change sometime down the road. Now that you know some of the history, theory and data behind dividend tax rates, you can more easily navigate any uncertainty to see attractive returns down the road.

For additional insights on taxes, be sure to check out 25 CPA Blogs That Will Make You A Better Investor.