President Barack Obama's 2013 election-year budget took investors by surprise with a call for significantly higher taxes on dividends, a major change from his earlier tax proposals and one that will raise the ire of dividend-paying companies.
Households earning more than $250,000 a year would see the tax they owe on dividends rise to a maximum of almost 40 percent next year, equal to the higher maximum income tax rate set to take effect in 2013. The current top income rate is 35 percent.
The Obama administration cited the need to raise funds to pay down the government's budget deficit and to make the tax code more progressive as reasons driving the policy change.
"Choices had to be made," a senior Obama administration official told reporters, explaining the bid to raise more than $200 billion over a decade with the steeper dividend taxes on the wealthy.
Obama again proposed raising the current 15 percent long-term capital gains tax rate to 20 percent for the wealthy. He had earlier also sought to set a 20 percent tax on dividends.
The tax-and-spending plan—seen largely as a political statement as he campaigns for reelection in November—focuses on new taxes from the wealthy and big corporations.
The plan he sent to a politically divided Congress on Monday is likely to win little favor, and most provisions are unlikely this year to become law, including the dividend tax increase.
“This is a reversal of what was a very specific policy feature of the first three budgets to keep dividends and capital gains taxed at the same rate,” said Michael Mundaca, a former top Treasury tax official under Obama, now at the accounting firm Ernst & Young.
“Companies may be more likely to retain earnings or seek alternatives ways to distribute their earnings such as by buying back stock,” Mundaca said.
Double Taxation Cited
Companies complain that dividend taxation is a double tax, adding an individual investor tax on top of the corporate tax.
Suggesting that this argument is over-stated, William Gale, an economist at the centrist Tax Policy Center, has written that half or more of dividends are not taxed because they flow to pension funds, retirement plans and other nonprofits.
Backers of lower dividend taxes also point to data showing that older investors are more likely to benefit from dividends.
The justification for keeping capital gains rates low—preventing investors from artificially holding onto investments when they want to sell—is not as relevant for dividends, the senior administration official said.
"The U.S. income tax had dividends treated as ordinary income from 1913 to 2003 so we're really going back to the long term tradition," the official said.
Companies also say boosting dividend taxes will sap economic growth. President George W. Bush cut dividend and capital gains taxes in 2003, and the economy grew for several years, but it is impossible to sort out the impact of the tax cuts.
Kenneth Kies, a tax lobbyist for major Fortune 500 companies at the Federal Policy Group, noted that the top tax rate for high-income individuals could exceed 43 percent in 2013 once taxes from the health care reform law are imposed.
Facing higher dividend taxes, businesses may accelerate 2013 dividend payments into 2012 to dodge tax hikes, he said.
"I wouldn't be surprised if we see moving all their 2013 dividends into 2012," Kies said. "A lot of U.S. companies are sitting on cash."
Currently, taxes on dividends and capital gains are capped at 15 percent for all taxpayers.
(Editing by Kevin Drawbaugh and Cynthia Osterman)