Double Taxation?

DOUBLE TAXATION?….Need another reason to be pissed off about the Bush tax cut for the super-rich? Look no further. Paul Krugman’s column today pointed out something I didn’t know, and it’s pretty important. I’m surprised it hasn’t gotten more attention.

One of the problems with having different tax rates on different types of income is that instead of encouraging economically productive behavior, it sometimes encourages people to simply shift income around into the lowest tax vehicle available. Cutting dividend taxes has exactly this potential for business owners: since high incomes are taxed at the personal rate of 35%, why not simply pay yourself (or others) a dividend instead of a straight salary? Dividend income is now taxed at only 15%, after all, and the difference between a salary and a dividend is surprisingly subtle.

In the original Bush proposal, this wasn’t possible because the dividend tax reduction applied only to companies that reported profits at least equal to the dividends being distributed. You couldn’t just set up a bogus tax shelter because it would have to show a profit and pay federal tax before distributing a dividend. Alternatively, if the shelter didn’t show a profit, then the dividends would be taxed at the old rate. In both cases the total tax take would end up being about the same as the personal tax rate, so what’s the point?

With me so far? Here’s the kicker: in the final tax bill, the profitability requirement was removed. As Krugman says:

The tax cut ? originally billed as a way to reduce abuses ? may well usher in a golden age of tax evasion. We can be sure that lawyers and accountants are already figuring out how to disguise income that should be taxed at a 35 percent rate as dividends that are taxed at only 15 percent. Since there’s no need to show that tax was ever paid on profits, tax shelters should be easy to construct.

Back in January the Wall Street Journal assured us that the dividend tax cut would apply only to companies that paid taxes. Not only was this because the noble purpose behind it was to eliminate the dread “double taxation,” but it had the side benefit of forcing companies to prove they had earnings, thus introducing a bit of much needed “sunshine” into corporate accounts.

In the end, the sunshine is gone and we’ve done far more than eliminate double taxation. In the case of corporations ? such as Treasury Secretary John Snow’s CSX ? that pay low or no taxes already, the dividend tax cut means that we’ve eliminated practically all taxation on a broad swath of income. Who are the lucky duckies now?

UPDATE: Just in case you’re wondering: yes, the whole thing is actually more complicated than this ? but that’s why God invented tax lawyers, right? Some of this abuse could have happened even with the profitability requirement, but without it the sky is, potentially, the limit.