Shareholders Don’t Like High Taxes Either

January 15, 2015

Corporations have received a lot of scrutiny for their tax planning strategies, but what about shareholders? An article in yesterday’s Wall Street Journal sheds light on some of the planning techniques that are used to avoid high dividend taxes:

Dividend-arbitrage trades in general are designed to place ownership of shares in lower-tax-rate countries for the purpose of minimizing dividend taxes upfront or generating repayment claims. Most of the trades are considered legal. They generate more than $1 billion in annual revenue for banks, the Journal reported last year.

Still, such trades have become controversial among regulators such as the U.S. Federal Reserve, which the Journal reported has expressed concerns about potential legal and reputational harm. German prosecutors have said the cum/ex subset of dividend-arbitrage strategies were illegal.

Tax-law changes started making the trades more difficult in 2010. Before that, some small firms made hundreds of millions of dollars from the strategy, industry officials said.

This is a serious concern, given that the U.S. has one of the highest dividend tax rates in the developed world – 9th highest in the 34-member OECD.

It also calls into question an idea that some have promoted: that corporate taxes should be reduced in exchange for higher taxes on dividends and capital gains. For example, Alan Viard and Eric Toder have proposed eliminating the corporate tax and instead taxing dividends and capital gains at ordinary tax rates, i.e. 39.6 percent at the federal level, and also taxing capital gains as they accrue rather than when they are realized. Such a high federal tax rate, combined with state taxes, would give the U.S. the highest capital gains tax in the OECD and the third highest dividend tax. In some high tax states, such as California, it would be the highest dividend tax in the OECD.

Certainly, there are many reasons to eliminate the corporate tax, as Viard and Toder explain. One of those reasons is that it is difficult to track profits across borders, so multinational corporations can to some extent book profits where taxes are lowest, either by accounting methods or by moving real activity. However, it appears shareholders also have a few tricks up their sleeves.

Ultimately, shareholders do what they do, for the most part, for a profit, plain and simple. Just like corporations. And both the investor and the business decision maker have many alternative uses for their money. If their returns are too heavily taxed, they will reduce investment and instead do something more fun, like go on a vacation.

This is the general problem with taxing capital, and why standard economics says capital income taxes should be zero, including corporate and shareholder taxes. The sooner policy makers realize this, the sooner the U.S. will become competitive again in terms of taxes.

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