Eliminating ‘Double Taxation’: The Dividend Imputation Alternative

By Brett Wilkinson and Marcy M. Fancher

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The imputation system approach to double taxation is well tested. Although it introduces some complexity, it measures up well under traditional tax policy evaluation criteria. In contrast, the 2003 Tax Act represents a partial solution to the problem and one that appears to be founded more on political expediency than on sound economics.

Problems with the Partial Solution

The 2003 Tax Act’s approach effectively amounts to a reduction (rather than the elimination) of double taxation. As with prior law, corporate income is still taxed at the corporate level and dividends are still taxed in the hands of shareholders. The difference is that dividends are not taxed at the shareholder’s marginal rate but rather at a reduced rate consistent with the treatment of capital gains.

For example, if we assume that $100 of income is earned at the corporate level and taxed at 35% with the remaining $65 being fully paid out as a dividend, then an additional 15% tax ($9.75) will be imposed at the individual level. The result is an effective tax rate of 44.75% on corporate income; this is lower than the former system, but still a significantly higher rate than is applicable to other forms of organization.

This approach fails to capture the true spirit of tax integration, which is about eliminating the friction between the corporate and the individual tax systems by “integrating” them into one system. A partial solution creates new problems.

The first problem with the new system is that because an element of double taxation remains, the biases of the prior system (such as the biases toward debt financing, toward retention of earnings, and against the corporate form) also remain. These biases are clearly reduced, but no tax system should bias behavior in directions not intended by policymakers.

The second problem arises because the 2003 Tax Act does not differentiate between dividends paid from previously taxed corporate income and dividends paid from corporate income that has been shielded from tax, a distinction that was a key feature of the original Treasury plan. Thus, income that is not taxed at the corporate level can be passed through to shareholders with an ultimate effective tax rate of no more than 15%. Critics have noted that this creates an incentive to engage in artificial and contrived tax shelters.

A third problem lies in the equity implications of the change in the treatment of dividends. Prior to the 2003 Tax Act, dividends were taxed at the shareholder’s marginal tax rate. Under the new law, dividend income is now effectively removed from the progressive rate structure, which reduces some of the equity between recipients of dividends. To minimize this concern, the 2003 Tax Act provides that individuals in the 10% and 15% brackets will pay a dividend tax of only 5%. Some concern remains as to the treatment of middle-income taxpayers. For example, married taxpayers with a combined taxable income over $58,100 will bear an identical level of tax on their dividend income as taxpayers in the highest income bracket.

Collectively, these problems are evidence that although eliminating double taxation is a desirable policy objective, adopting a partial approach can introduce distortions that could have been avoided had alternate mechanisms been used. One such mechanism is the dividend imputation system, or shareholder credit system, which has been used in other developed countries and which was the integration approach advocated by the AICPA in the mid-1990s.

The Dividend Imputation Alternative

Dividend imputation operates to ensure that distributed corporate income is taxed at the individual shareholder’s rate, with the corporate tax serving effectively as a form of withholding tax on corporate income. This integration of the corporate and individual systems works as follows.

As corporate income is earned, the corporation pays the applicable corporate tax on that income. When a dividend is paid, each shareholder receives a tax credit reflecting the underlying corporate tax already paid. The shareholder is taxed on the “grossed-up” dividend (the dividend plus the tax credit) at his marginal tax rate, but applies the tax credit to reduce his overall individual tax liability. If the shareholder’s marginal tax rate is higher than the corporate tax rate, then the shareholder will have an additional liability to pay. If the shareholder’s marginal tax rate, is below the corporate rate, then there will be an excess credit that may be used to offset tax liability on other income (such as salary) or may be refundable. As noted above, the result of this process is that the ultimate tax rate applied to dividend income is the shareholder’s marginal tax rate. The Exhibit shows an example of the operation of the dividend imputation system.

Analysis

Tax policy analysts typically measure any tax change against three criteria: efficiency, equity, and simplicity. The dividend imputation system substantially meets these criteria as a means of integrating the corporate and individual tax systems.

Efficiency. Efficiency, or neutrality, is a measure of how much tax policy unduly influences the behavior of taxpayers. Three particular biases emerge under the double-taxation system: the bias toward debt financing rather than equity financing; the bias toward retention of earnings; and the bias against the corporate form. As noted earlier, recent changes reduce but do not eliminate these biases.

The results of dividend imputation systems in other countries have generally been consistent with expectations. For example, researchers have found that introducing dividend imputation systems in Canada and New Zealand substantially reduced corporate debt-to-equity ratios, a result consistent with the elimination of the debt bias. Similarly, researchers in Australia and New Zealand have found evidence of an increase in corporate capital investment following the introduction of dividend imputation. The increase reflects the decreased cost of corporate equity capital.

Equity. This second criterion by which tax systems are evaluated is concerned with the “fairness” of the tax burden. The double taxation of dividend income violates equity because the tax burden on investors varies with the source of the income (e.g., dividends versus interest). In contrast, dividend imputation eliminates this distinction by ensuring that distributed corporate income is taxed at the shareholder’s marginal rate. Unlike the new law, which simply removes dividends from the progressive rate structure (but continues to tax them), the dividend imputation approach operates within the progressive rate structure, ensuring a comparable treatment of income, irrespective of source.

Simplicity. When a system is overly complex, compliance costs escalate and taxpayers and their advisors have more incentive to “beat the system.” As noted above, the 2003 Tax Act creates incentives to use abusive tax shelters. In contrast, dividend imputation reduces the incentives to artificially lower taxable income at the corporate level because distributed corporate income is ultimately taxed at the shareholder’s marginal rate regardless of the corporate rate. Research in New Zealand found some evidence that corporate tax minimization strategies were used less where shareholders were able to benefit from tax credits.