Why [qualified] dividends are taxed differently from current income?

Question

I am wondering what was the motivation to decouple taxation (USA) of short-term gains/income from dividends in 2003.

Before 2003, dividends were mostly taxed as current income, at a significantly higher tax rate compared to long-term capital gains. However, in 2003, the situation flipped with both capital gains and dividends being taxed at 15%. (I guess now as of 2021, the highest bracket is 20% for capital gains and dividends).

I got this question while I was reading "Unconventional Success: A Fundamental Approach for Personal Investment", by D. F. Swensen, where the following table is taken from:

As I understand, the table assumes dividends to be qualified dividends which were introduced by Jobs and Growth Tax Relief Reconciliation Act of 2003, which is linked to a "bucket" of Bush tax cuts.

The general topic of tax cuts, in general, and Bush tax cuts, in particular, are a bit too broad—so, I want to be very specific. In my view, dividends are very similar to current income. I have a hard time justifying the taxation of dividends differently from regular income. I read the Why are dividends different from property income like rent?, and while it was interesting and insightful, I am coming more from a taxation point of view (and that question did not have a clear consensus anyway).

So, I wonder, what were (and, I guess, still are) the main motivations for "relaxed" taxation on qualified dividends? Why they are tax-differentiated from current income?

Answer 1

It's because the dividend money is already taxed at the company level. To understand this best, compare what happens if you invest $1000 in a company via stock, vs investing $1000 in a company via bonds. Assume for the sake of convenience both the dividend yield on the stock and the interest on the bond is 3%.

Interest is a business expense and so paid with pre-tax money, while dividends are paid with after tax money. At the time corporate tax rates were 35%, so, the company had to make roughly $46.25 worth of profit and pay $16.25 taxes in order to have $30 to give you as dividend. For the bond, they only had to make $30 in order to give you $30 in interest. The dividend money is taxed twice, once at the company level, and again at the individual level, while interest is only taxed once, at the individual level.

If you as the individual stockholder were taxed at what was the highest rate of 39.6%, that meant that that $46.25 of profit was shrunk all the way down to $18.12 -- the government ended up with $28.13 of it, or almost 61%.

So, that's the problem the qualified dividend tax rate of 15% was meant to address. Your after-tax money in your pocket for that $46.25 of profit would then be $25.50, with the government taking $20.75 combined for "only" a 44.8% tax bite.

The bonds here are still advantaged, since $46.25 (to compare apples to apples) profit made and paid out as interest, taxed at the top personal rate of 39.6%, would see the bond holders with $27.93 in their pocket, with the government taking $18.32.

Personally, I thought it would make a lot more sense to have the dividends paid out of pre-tax money like interest, and leave the tax rate for the individual at whatever their income tax rate is. But no one asked me.

Answer 2

Congress and the President want to change how an item of income was taxed. This would change how people invest their money.

All tax changes boil down to one of three reasons:

• Bring in additional income to the government.
• Reward people who have a specific type of income/expense
• Punish people who have a specific type of income/expense.

If I drop a tax rate, that rewards a group of people. If I make something deductible that wasn't before, then I reward a group of people. If I do the opposite things, I punish others.

In the Bush tax cuts the Congress and the President changed items in the tax code to do exactly that. People who have income from dividends and capital gains were seen as people who had investments that lead to additional jobs. So reward them so they funnel more money into those types of investments.