‘Double Taxation’: The Dividend Imputation Alternative
Brett Wilkinson and Marcy M. Fancher
tenet of the 2003 Jobs and Growth Tax Relief Reconciliation
Act is the reduction in the “double taxation”
of corporate income through a reduced rate on dividend income.
While the law marks a dramatic shift in the U.S. tax system
(where efforts over the last three decades to eliminate
double taxation have consistently failed), it falls well
short of the reforms in other industrialized countries and
deviates substantially from the U.S. Treasury “Blue
Book” proposals for reform released in February 2003.
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.
with the Partial Solution
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.
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.
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.
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.
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.
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
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.
Dividend Imputation Alternative
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.
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
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
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.
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.
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
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.
Wilkinson, PhD, is an assistant professor of accounting,
and Marcy M. Fancher is a graduate student
of accounting, both at the Hankamer School of Business, Baylor
University, Waco, Texas.