Dividend Taxes Simplified

June 6, 2013

A widgets corporation has two shareholders: Tobias and Lindsey. Every year, the corporation pays out all its profits to its two shareholders who each own equal shares (maybe not a great business decision, but works for this example). Tobias and Lindsey live in a country with no dividend or corporate tax.

In year one, the corporation earns $100 in profits, which is divided between the two shareholders with each Tobias and Lindsey earning $50. Both Tobias and Lindsey are happy and they use their money to throw a fundraiser for charity.

At the end of year one, the country decides it will institute a dividend tax of 23.8 percent for all years going forward. Again, the corporation earns $100 in profits, which is divided equally between Tobias and Lindsey. Tobias and Lindsey take their $50 and pay the 23.8 percent tax, giving their country $11.90 and leaving each of them with $38.10. Both Tobias and Lindsey are a little less happy because they have to throw a slightly smaller fundraiser than in year one.

At the end of year two, the country decides that the dividend tax is not enough, so in addition they institute a corporate tax of 35 percent for all years going forward. The corporation, consistent as always, earns $100 in profits. But this time, before it pays its two shareholders, the corporation pays its 35 percent tax of $35 to the country, leaving the widget company with $65 to pay its shareholders. The corporation pays Tobias and Lindsey the after tax profit of $65 with each receiving $32.50. They take their $32.50 and pay the 23.8 percent dividend tax rate, or $7.74, leaving both parties with $24.76 each. Tobias and Lindsey as much less happy and no longer have the money to throw a fundraiser.

So, who pays the dividend and corporate taxes?

Each year Tobias and Lindsey faced a different tax regime. In year one, the effective tax rate for both Tobias and Lindsey was 0 percent, because they faced no taxes.

In year two, the addition of the 23.8 percent dividend tax decreased their income by $11.90 for an effective tax rate of 23.8 percent.

In year three, despite the 35 percent tax being levied on the corporation, Tobias and Lindsey’s effective tax rate goes up to 50.1 percent, with $13.34 of the total tax burden due to the corporate tax and $11.90 due to the dividend tax.

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