Bush Tax Plan Could Slam Pensions

By: Stephen M. Breitstone
Long Island Business News
February 7, 2003

For the past 25 years, the elimination of the double taxation of corporations - often referred to as "integration" - has been high on the list of reforms under consideration by the Treasury Department and the tax bar. Integration has been largely accomplished in the closely held context through adoption and expansion of the "S" corporation rules and the advent of limited partnerships and limited liability companies, or LLCs.

These forms of doing business provide great latitude for closely held businesses to avoid the double taxation of traditional "C" corporations. The Bush Administration's proposal to eliminate the taxation of dividends really targets public corporations for which the pass-through taxation of "S" corporations and LLCs and partnerships is not available.

No doubt the government spends many millions of dollars to hire economists, lawyers and scholars to study the effects of changes in the tax law. Numerous studies are prepared and published each year by the government analyzing these issues in excruciating detail. The objective is to establish sound tax policy and to avoid the dreaded "unintended consequences."

I doubt that the Bush Administration's proposal to eliminate the taxation of dividends derives from such a deliberative process. Unfortunately, this proposal seems ill conceived, a politically motivated ploy to prop up the ever declining stock market for the short run. This proposal, if enacted, would have a severe negative impact on the American working class and seniors, who look to pensions as their principal source of retirement income.

This is the same category of taxpayer that will probably have difficulty relying upon Social Security benefits to be paid from a soon-to-be-bankrupt Social Security system.

I believe that an "unintended consequence" of the elimination of taxation on dividends will be that there will be a reduction - by approximately 40 percent - in the levels of dividends paid to pension funds on investments in stocks that currently pay dividends. For those dependent on pensions for their retirement (i.e., people who work for a living), this tax reform could be a disaster.

This type of "knee jerk" tax reform is reminiscent of the Tax Reform Act of 1986, which was supposed to eliminate tax shelters. That legislation did eliminate some tax shelters but it created others. It also triggered the worst real estate recession since the Great Depression and prompted the savings and loan crisis, which ultimately required a massive governmental bailout of that industry.

Reform of our tax system is clearly necessary, but it must be measured and incremental. Otherwise, the "unintended consequences" can be severe.

Here's why the Bush Administration's proposal to repeal the dividend tax could be another ticking time bomb. Corporations pay dividends because that is what the marketplace demands. The level of dividends paid is designed to stay competitive with other investments. In comparing alternative investments, the marketplace compares "after-tax" yields. If dividends become non-taxable, the level of dividends that must be paid to attain a competitive after-tax yield would be lower. This is like tax-exempt municipal bonds, which pay a lower rate of interest than their taxable equivalent bonds. With bonds, there is a two-tiered system of taxable and tax-exempt bonds. Pensions normally do not purchase tax-exempt bonds because they do not benefit from the tax exemption. In the market, they can earn higher yields with taxable bonds.

Over the next decade, I doubt the government is prepared to "bail out" people who rely on pensions. There will no doubt be other priorities that are more compelling - namely, bailing out Social Security.

The Bush Administration needs to take a step back and reconsider its tax agenda.