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Dividend Tax Cut may create large loopholes

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Dividend-Tax Cut Runs Risk

Of Opening More Loopholes

Congress calls the tax bill it's now considering the Jobs and Growth Tax Act of 2003, but it's at risk of passing the Great Tax Shelter Act instead.

The president's plan to eliminate the tax on dividends rests on a couple of respectable principles: The tax code shouldn't push U.S. companies to rely more on borrowing and less on selling shares of stock to raise money. And if government wants more of something -- in this instance, more saving and investment -- it ought to tax it less.

Turning those principles into policy proved troublesome from the start.

The best way to change corporate behavior would be to change the taxes that companies (not shareholders) pay, perhaps by letting firms deduct dividends as they do interest payments. But after Enron Corp., no politician wanted to sell a corporate tax cut. And roughly half of all dividends go to shareholders that don't pay U.S. income taxes, such as college endowments, pension plans and foreigners. Those profits aren't taxed twice (once when earned by the company, once when paid to shareholders as dividends).

When the White House asked the Treasury to turn a slogan -- "end the double taxation of dividends" -- into tax policy, the Treasury dusted off a plan crafted in the waning days of the first Bush administration. It quickly dropped the original plan's out-of-favor notion of cutting some taxes and raising others to avoid enlarging the budget deficit.

The Treasury did attach complex provisions designed to make sure that companies pay taxes on profits before turning them into dividends. After all, according to MIT economist George Plesko's estimates, roughly one-third of all dividends are paid from profits on which corporate taxes have never been paid -- either because companies took advantage of tax breaks created by Congress to encourage, for example, investments in research or housing for poor people, or because companies exploited unintended tax loopholes.

Lobbied hard by those who sell and use corporate tax breaks, Congress rejected those Treasury proposals. The House opted for a mercifully simple cut in the top tax rate on dividends to 15% from 38.6%. The Senate went for a temporary elimination of the dividend tax and threw in assorted provisions aimed at curbing corporate tax abuses. But it skipped the Treasury provisions designed to make sure that profits are taxed at least once.

The Treasury says it hopes the final compromise would include its original language so that the tax cut delivers on "the president's principle that the government tax dividends once and only once."

But neither the Treasury nor the White House pounded the table. "There is a lot of pressure so the administration can claim a symbolic victory, but when the symbolism leads to an abandonment of principles, you've got a problem," says Gene Steuerle, an Urban Institute tax economist.

The problem sounds technical, but it has big-bucks consequences; the Treasury estimates them at more than $35 billion over 10 years.

The capacity of companies and rich investors to exploit, and sometimes create, tax loopholes appears almost unbounded. Taxing one kind of income a lot more than another creates incentives for tax games. Eliminating or sharply reducing the tax on dividends, without making sure that companies pay taxes, can offer all sorts of opportunities to the tax-averse.

"To the extent that you can pay tax-free dividends out of profits that have never been taxed, then it's 'Katy, bar the door' on tax shelters," warns Michael Graetz, a Yale Law School professor who helped devise the first Bush Treasury tax plan.

Unless the Treasury can write some air-tight rules, a rich investor might, for instance, borrow money and deduct interest payments (against taxable investment income) on his own tax return, then use the money to buy shares of stock on which he would earn a tax-free dividend paid from profits that have never been taxed. Bottom line: The profits are never taxed, not even once, and the economy gets no new capital or savings because the investor borrows the money that he uses to buy the shares.

And that's before highly paid wizards on Wall Street and in accounting and law firms find really clever ways to use the new law to help wealthy clients avoid taxes.

Updated May 22, 2003 2:58 p.m.

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