Welcome to the deep dive. Today, we're getting
into something that on the surface might seem
a bit dry, the dividend tax. Right. Sounds like
something just for accountants. Exactly. But
we're going to show you that this is so much
more than a line on a tax form. It's really a
battleground for big ideas, economic theory,
political philosophy, even global competition.
It really is. The way a country decides to tax
dividends says a lot about what it values. And
our source material for this is a really extensive...
overview of global dividend tax policies. So
our goal here for you is to have you walk away
with a solid grasp of what this tax is, why it
kicks off this huge double taxation debate. A
very fierce debate. Oh, absolutely. And also
how differently countries all over the world
handle it, which in turn creates these wildly
different incentives for companies and for investors.
So let's just dive in. First principles. What
exactly is a dividend tax? The simplest terms.
In simple terms, it's a tax that a government
levies on dividends. And those dividends are
just the slice of a company's profits that it
decides to hand out to its shareholders. It's
basically a tax on the income you get from owning
a piece of a company. Okay. And who actually
pays it? Because it's not always as simple as
the shareholder just writing a check. No, not
at all. That's a great point. The primary legal
liability, so the actual obligation, that rests
with the shareholder who gets the money. But,
and this is a big but. In a lot of systems, the
corporation paying the dividend has to apply
a withholding tax. So they hold back a certain
percentage, say 15 or 30 percent, and pay that
straight to the government. Before the investor
even sees it. Before the investor sees a dime.
Now, for someone investing in their own country,
that withheld amount is usually just a credit
towards their final tax bill. But for an international
shareholder, that withholding tax might be the
only tax they pay in that country. It's a huge
deal for tax treaties. And this right here brings
us to the core issue, the central tension we're
going to be talking about all day. This tax is
applied on top of the corporate income tax. Exactly.
The company makes a profit. It pays tax on that
profit. Then it distributes some of what's left
and that distribution gets taxed again. That's
the double taxation everyone's always arguing
about. The same dollar of profit is getting hit
twice. That's the phrase that defines the entire
landscape. It's taxed at the entity level, the
corporation, and then again at the investor level,
the shareholder. So naturally, because the second
tax exists, companies and their owners have found
some, let's say, creative ways to get money out
without actually calling it a dividend. What
are the main strategies they use? The biggest
one, and you see this everywhere, is the share
buyback or share repurchase. This is the go -to
move in any country where the tax on capital
gains is lower than the tax on dividends. OK,
so walk me through that. Why is a buyback different
from a dividend from a tax perspective? It's
all about classification. When a company pays
you a cash dividend, that's usually taxed as
ordinary income or whatever the specific dividend
tax rate is. But when the company buys back its
own shares, the shareholder is effectively selling
an asset. Ah, so it becomes a sale. It becomes
a sale. And that generates a capital gain, which
in most places is taxed at a much lower preferential
rate. So if your capital gains rate is, say,
15%, but your dividend rate is 35%. It's a no
-brainer. The shareholder has a massive tax incentive
to pressure the company to do buybacks instead
of dividends. It's a very efficient way to turn
highly taxed income into lower taxed income.
And it also has the side effect of potentially
boosting the stock price for the remaining shares.
A kind of win -win for the shareholders, even
if it's not always the most productive use of
that cash. Absolutely. The second big strategy
is, well, even simpler. Just don't pay anything
out. Retained earnings. Retained earnings. The
corporation just holds onto its surplus cash.
That increases the company's book value and,
in theory, the market value of the shares over
time. And you only pay tax on that growth way
down the line when you finally decide to sell
the stock. Exactly. The tax is deferred. And
when you do pay it, it's at that lower capital
gains rate. So you get deferral and a lower rate.
It's a very powerful tool for building wealth,
even if it means capital gets sort of locked
up inside the company. Right. Now, with private
companies, it seems like it would be really easy
for the owner to just borrow money from their
own company forever instead of taking a dividend.
How do governments stop that? That's a huge loophole,
and that's where deemed dividend rules come in.
This is critical anti -avoidance law in a lot
of countries. Deemed dividend. Yeah. For a private
company, the owner could just use company money
to buy a car, pay for a vacation, or take a giant
low -interest loan. They're getting the benefit
of the profits. Without the tax bill of a dividend.
Precisely. So to shut that down, tax authorities
have rules that deem those kinds of transactions,
like a loan that's not at a commercial rate.
or a salary that's way too high for the work
being done. They treat it as if it were a formal
dividend for tax purposes. If they didn't, the
dividend tax would be basically optional for
any small business owner. That sets the stage
perfectly. You have the tax, but you also have
these powerful incentives to work around it.
Okay, let's go back in time for Section 1 and
trace how this whole thing started. The U .S.
history is a great place to start because it's
just been so... volatile. It's been a real roller
coaster. But if you look at the origins of income
tax systems in general, you see this philosophical
fight over dividends right from the beginning.
In the very early days, there was a strong argument
to just exempt them completely. And the logic
there was simply to avoid double taxation. Yes,
that was the core principle. The economic thinking
was, look, the corporation already paid tax.
Hitting the shareholder again is just unfair,
discourages investment. And that idea of fairness
was actually pretty powerful in shaping early
tax law. But I imagine the government's need
for money eventually won out. It always does,
doesn't it? The first real documented dividend
taxes pop up in the 17th century. We see them
in places like the Netherlands and England. The
big commercial powers of the time. Exactly. They
had sophisticated markets and they realized that
profits going to capital owners were a clear
taxable source of wealth. Yeah. Then as you move
into the 19th century and more countries adopt
modern income taxes, the dividend tax becomes
pretty standard. It's a reliable source of revenue.
OK, so let's zoom in on the U .S. The story really
kicks off in 1913. Right. With the 16th Amendment,
which gave Congress the power to levy an income
tax. The Revenue Act of 1913 that followed. it
created a really gentle tax system. The personal
income tax was just 1%, with a few surtaxes on
top for the wealthy. And the corporate tax was
also 1%. So how did they handle dividends in
that very first system? It wasn't full -on double
taxation, was it? No, it was actually a really
interesting compromise. They were clearly trying
to avoid that double hit. So dividends were completely
exempt from that main 1 % personal income tax.
But, and this is the key, they were not exempt
from the surtaxes. which only kicked in for incomes
over $20 ,000, a huge amount of money back then.
So it was a way to tax the dividend income of
the very wealthy without hitting small investors
with that double whammy. Exactly. It was a kind
of an early, maybe clumsy attempt at integrating
the two tax systems. But that nuance didn't last
long. The Great Depression changed everything.
It really did. The government was desperate for
revenue to fund New Deal programs. So between
1936 and 1939, Congress just reversed course
completely. Dividends were made fully taxable
at the individual's ordinary income tax rate.
So the double taxation argument just went out
the window. It took a backseat to the national
emergency. That period is really what established
the principle of full classical double taxation
in the U .S. system. So what happened after the
war? Did they stick with that high tax model?
No, the pendulum started to swing back. The 1950s
brought a new focus on, you know, encouraging
investment and capital formation. The Tax Reform
Act of 1954 was a big step. It created a separate
lower rate for dividends. An acknowledgment that
the full rate was maybe too punitive. Right.
And that was built upon in 1981 with another
act that brought in more exemptions and credits,
all designed to lessen the tax burden on dividend
income. So we swing from full taxation to preferential
treatment. But then it swings back again in the
80s. A huge swing back. For an 18 -year period.
From 1985 all the way to 2003, dividends were
once again taxed at the same rate as ordinary
income. The big push at the time, especially
the Reagan -era reforms, was for simplification.
A flatter, simpler tax code. Exactly. Treat all
income the same. But that meant if you were in
the top bracket, your dividends could be taxed
at rates well over 40%, sometimes climbing towards
50%. That was really the high watermark for double
taxation in the modern U .S. Which brings us
to probably the single biggest shift in a century,
the Bush tax cuts in 2003. What was the thinking
behind that dramatic cut? It was a mix of things.
There was a desire for economic stimulus after
the dot -com bust and the recession, and a very
strong philosophical argument against double
taxation. President Bush made it a centerpiece
of his platform, arguing it was just unfair and
bad for the economy, especially for seniors living
on investment income. And the result was the
JGTRRA. The Jobs and Growth Tax Relief Reconciliation
Act of 2003. A mouthful. But it completely changed
the landscape by creating this new category called
a qualified dividend. And suddenly that term
was everywhere. What was the magic of being qualified?
The magic was that your dividend was no longer
taxed at your ordinary income rate. Instead,
it was taxed at the much, much lower long -term
capital gains rate. All of a sudden, income that
might have been taxed at... 35 or almost 40 %
was now taxed at a maximum of 15 % for most people.
That is a massive shift. A monumental victory
for opponents of double taxation. But those rates
were temporary. They were set to expire, which
created this huge fiscal cliff situation about
a decade later under the Obama administration.
A huge moment of drama. If they had done nothing,
the rates would have snapped back to the old
system. Top rates back near 40%. To avoid that
shock, which people were calling taxmageddon,
Congress passed the American Taxpayer Relief
Act of 2012, or ATRA. And ATRA was a compromise,
right? It kept the low rates for most people
but added a new, higher tier. That's exactly.
It made the Bush era rates permanent for lower
- and middle -income taxpayers, but for the highest
earners. We're talking people with incomes over
$400 ,000 or $450 ,000. It raised their qualified
dividend rate from 15 % up to 20%. So let's just
nail down how it works now, since 2003. It's
not one flat rate for everyone. No. It's very
progressive. It's tied to your ordinary income
tax bracket. So people in the lowest brackets,
the 10 % and 15 % brackets, they initially paid
a 5 % tax on their dividends. But here's a wild
detail. From 2008 to 2012, that rate was cut
to zero. 0%, a federal tax rate of zero on dividend
income. Zero. It's a huge incentive for people
just starting out or for retirees. And that 0
% rate has mostly stayed in place for those lower
brackets. Yeah. Then you have the big middle
chunk of taxpayers. They've consistently paid
15%. And only the very top earners, the ones
in the highest income bracket, pay that 20 %
rate. But wait, there's another layer, something
that came in with the Affordable Care Act, the
NIIT. Yes. You can't forget the net investment
income tax. It's a crucial part of the modern
system. It came into effect in 2013. And it's
a separate 3 .8 % tax that applies to, well,
net investment income. So that includes dividend.
It includes dividends, capital gains, rent. all
that passive income. And who pays this extra
3 .8 percent? It's specifically targeted at high
earners. It kicks in for married couples with
a modified adjusted gross income over $250 ,000
and for single people over $200 ,000. And it's
in addition to the regular dividend tax. It's
not a replacement. And the really critical thing
about that threshold, the $250 ,000, it's stuck.
That's the part people miss. It is not indexed
for inflation. So every single year. As wages
and prices rise, more and more people are going
to cross that line and get hit with this extra
tax. It's what's known as bracket creep. So a
tax that was meant for the very wealthy will,
over time, start to affect more of the upper
middle class. That means that the top effective
federal rate on qualified dividends today is
23 .8 percent. The 20 percent plus the 3 .8.
And that number is just going to apply to more
and more people as time goes on. It's just a
perfect summary of the whole story. A century
of swinging back and forth, ending with this
incredibly complex tiered system with this extra
unindexed levy on top. It shows there's just
no consensus. That lack of consensus is the perfect
entry point for Section 2, the core conflict.
Let's unpack the arguments. Why do some people
see this tax as completely necessary and fair?
Let's start with the pro -tax side, the separate
entity perspective. Okay, so the whole foundation
for this argument is the legal basis of a corporation.
The idea that a corporation is, legally speaking,
a person. It's a separate entity from its owners,
with its own rights and its own responsibilities.
And the single biggest benefit it gets from being
a separate person is limited liability. Absolutely.
That is the holy grail. It means if the company
fails... If it goes bankrupt, your personal assets
are safe. The creditors can't come after your
house. You only lose what you invested. And the
argument is that this huge privilege isn't just
a given. It's granted by society. Exactly. It's
not a natural right. Yeah. So there has to be
a price for it. And our source material quotes
Professor Ahmadi on this. And he's a very clear
argument. I remember that. He says the corporate
income tax is the price you pay for limited liability.
And on top of that, this separate legal. person,
the corporation, it uses public goods. It uses
roads. It relies on courts to enforce contracts.
It benefits from a national defense. So it has
its own independent duty to pay taxes to support
all that. And the scale of this is just enormous.
The sources point out that while corporations
are less than 20 percent of firms in the U .S.,
they generate something like 90 percent of the
revenue. The economic power that comes from that
legal status is immense. So the logic follows.
If the corporation is person A and the shareholder
is person B, then when money moves from A to
B, that's a new taxable event, just like your
salary is a taxable event. So from that perspective,
it's not double taxation at all. It's just taxation,
two separate entities, two separate taxes. That's
the legal argument. There's also an equity argument.
Why should someone who earns money from sitting
on a pile of stocks be taxed less than someone
who earns it through their labor every day? A
very powerful political argument. OK, now let's
flip it completely. Let's look at the argument
against the dividend tax. This is the one you
hear from groups like the Cato Institute. Why
do they say it's so damaging? Their argument
is that the legal fiction is just that, a fiction.
The economic reality is that only people can
pay taxes. A corporation can't. And according
to economists at places like the Treasury and
the CBO, the burden of the corporate tax falls
almost entirely on the owners of capital. On
the shareholders. On the shareholders. So when
you tax the corporation and then tax the dividend,
you are, in economic reality, taxing the same
person twice on the same stream of income. And
they say this creates huge distortions in the
economy. Let's start with the one about debt.
This is probably the biggest one. Interest that
a company pays on its debt is tax deductible.
But dividends it pays on its equity are not.
The tax code subsidizes borrowing. It creates
a massive artificial bias towards debt financing
over equity financing. This encourages companies
to load up on debt, to become highly leveraged,
and that makes the whole economy more fragile.
When a recession hits, it's those highly indebted
companies that go bankrupt first, and that can
turn a small downturn into a major crisis. But
couldn't you argue that having debt forces managers
to be more disciplined? That's a counterargument
you hear, sure. The debt holders provide a layer
of oversight. But the response is that the tax
code should be neutral. It shouldn't be picking
winners and losers between debt and equity. The
market should decide the right capital structure,
not the tax code. OK, what about the second distortion,
the one about what executives do with all that
cash? This is the wasteful retention argument.
Because paying a dividend triggers that second
tax, there's a big disincentive to do it. So
what happens? The cash piles up inside the company.
Creating a huge war chest for the CEO. Exactly.
And that creates what economists call an agency
problem. The managers might be tempted to use
that cash on projects that boost their own egos.
like flashy mergers instead of projects that
are actually profitable for the shareholders.
So capital gets tracked inside a company earning
a 5 % return when the shareholders could have
taken it as a dividend and invested it somewhere
else for a 10 % return. That's the misallocation
argument in a nutshell. It starves the most productive
parts of the economy and bloats the less efficient
ones. This gets even more complicated when you
try to figure out what a shareholder's actual
income is. This is where hidden gains come in.
This gets a little technical, but it's so important.
Your true income as a shareholder isn't just
the dividend check you get. It's the total change
in the value of your shares. That includes things
like a company getting a new patent or cornering
a new market. Those things increase the stock's
value, but they're not taxed at the corporate
level right away. So when the dividend finally
gets paid. What are you actually being taxed
on? That's the tricky part. When a company pays
a $1 dividend, you get a dollar in cash. But
the value of your stock drops by about a dollar.
Your net worth hasn't changed at that moment.
The dividend tax is actually a tax on the past
growth and past earnings that are now being formally
recognized. I see. And that past growth is a
mix of things. Some of it was from those untaxed
hidden gains, but some of it was from profits
that were already hit by the corporate tax. So
it's a messy delayed tax that absolutely includes
a double hit on some of that money. And it's
that mismatch that drives all this tax planning
and strange economic behavior. Which is why our
sources say that a broadly accepted solution
to all these distortions, well... It's yet to
be found. The difficulty of finding any certainty
here is perfectly summed up by that story about
the French study. Oh, yeah. The 2022 study in
the American Economic Review. It was a huge deal
for a moment. It looked at what happened when
France jacked up its dividend tax rates. And
it found the opposite of what you'd expect. It
found that, yes, companies paid fewer dividends,
but they ended up reinvesting more of that money
back into their own businesses. Yeah. The initial
conclusion was, hey, maybe this tax doesn't cause
misallocation at all. Maybe it even reduces it.
But then the story takes a turn. A big turn.
The study was retracted. Other researchers found,
quote, inconsistencies in the data. It was a
huge controversy. Wow. To have a study in a top
journal retracted on a topic this big. It's a
massive cautionary tale. It just shows how hard
it is to get clean data and prove cause and effect
in this area. Even though the original authors
argued the issues didn't change the main results,
the retraction itself proves that policymakers
are often working with very shaky evidence. So
given all this controversy, what are the big
ideas for fixing this mess? They usually fall
into two buckets. You can either just lower the
rates on dividends, on capital gains, on corporate
profits to reduce the friction. Or you can go
for a more structural change to actually integrate
the systems. Like what? Well, you could let companies
deduct their dividend payments as an expense,
just like they do with interest. Or a cleaner
way might be to just make any dividend paid out
of already taxed corporate profits completely
tax -free to the shareholder. The goal is the
same. Make sure that stream of profit only gets
taxed once. Right. And that really gets us into
how different countries have tried to solve this.
So let's move to Section 3 and look at the global
picture because the variety is incredible. The
global data is fascinating, especially when you
compare a country's tax rate on capital gains
to its rate on dividends. That difference, that
spread, tells you everything about its policy
priorities. Because, as we said, that spread
drives the choice between buybacks and dividends.
Exactly. So let's look at the countries with
a big positive spread. where the dividend tax
is way higher than the capital gains tax. This
is a giant flashing sign that says... don't pay
dividends. And who's at the top of that list?
South Korea is the most extreme. They have a
massive 44 percentage point spread, a huge incentive
for buybacks. Belgium is next at 30 percent,
then Slovenia. These countries are effectively
forcing companies to retain cash or use buybacks.
Then you have the neutral countries, the ones
that try not to pick a side. Right. The countries
with a zero spread. And this list includes the
U .S., which makes sense given the changes in
2003. Who else is in that club? Denmark, France,
Germany, Japan, Spain, a lot of the big OECD
economies. For the U .S., it means the top rate
on qualified dividends is the same as the top
rate on long term capital gains. The policy is
officially neutral on how a company should return
cash to shareholders. And then there are the
weird ones, the countries with a negative spread,
where it's actually more tax efficient to receive
a dividend than a capital gain. This is much
rarer, but you see it. Estonia and Latvia have
a big negative spread of 20%. Greece is at negative
10. It's an unusual choice, maybe designed to
encourage companies to pay out cash quickly.
Beyond just rates, some countries have entirely
different systems. Let's talk about the imputation
system in Australia. How does that work? The
imputation system is, I think, a really elegant
solution to the double tax problem. It directly
connects the corporate tax to the shareholder's
tax. So let's use an example. A company earns
$100. The corporate tax rate is 30%. The company
pays $30 in tax. Right, so it has $70 left to
distribute as a dividend. Under an imputation
system, when it pays you that $70 dividend, it
also gives you a certificate, a franking credit,
for the $30 in tax it already paid. Okay. So
you, the shareholder, declare the full $100 of
pre -tax profit as your income. Then you calculate
your personal tax on that $100. Let's say your
personal tax rate is 47%. That means you owe
$47 in tax. But you have the $30 credit. Exactly.
So you apply that credit and you only have to
pay the remaining $70. The beauty is the total
tax paid on that $100 of profit, the $30 by the
company and the $17 by you adds up to $47, which
is exactly your personal marginal rate. the corporate
tax just becomes a prepayment. That's a really
clean way to solve it. It ensures the total tax
burden matches the individual's ability to pay.
It's a very effective integration system. Canada
does something similar but different with its
dividend tax credit. Canada also aims for integration,
but uses a gross -up mechanism. A Canadian shareholder
gets a dividend, they have to gross it out by
a certain percentage, and then they get a credit
to offset the tax. It's notoriously complicated
because of all the provincial rules, but the
goal is the same. Give the investor credit for
the tax the company already paid. And they made
a change in 2006 to distinguish between... Eligible
and ineligible dividends. What was that about?
That was a way to fine tune the system. Eligible
dividends come from profits that were taxed at
the high general corporate rate. Ineligible dividends
come from profits taxed at the lower small business
rate. The tax credit is bigger for eligible dividends
to make sure the total tax paid corporate plus
personal is roughly the same in both cases. OK,
let's go Asia. India is just a wild case study
in policy whiplash. It's an absolute roller coaster.
Before 1997, it was a classic system. The investor
paid the tax. Then in 97, they switched to a
dividend distribution tax, the DDT. So the company
paid the tax instead. Right. Which made the dividend
tax free for the investor. But that only lasted
five years. In 2002, they scrapped it and went
back to the old system. And how did the market
react to that? It hated it. The sources say it
caused negative sentiments and stock prices fell.
So what did the government do? They switched
back. They switched back. In 2003, the DDT was
back in. But they kept tweaking the rate upwards
for the next 17 years. Then in 2020, they scrapped
it again. They scrapped it again. They went back
to taxing the investor. The main reason this
time was to attract foreign investment. Global
investors find it much easier to claim tax credits
back home when they're the ones paying the tax
in India. It just shows how policy gets pulled
between domestic needs and global competition.
It really does. OK, let's round out the world
tour with a few examples from Europe and, of
course, the places with no tax at all. In Germany,
they have a flat withholding tax, the Erbgeltungsteuer,
of 25%. Then they add a 5 .5 % solidarity tax
on top of that. So the total comes out to about
26 .4%. It's a simple flat rate on passive income.
The UK, on the other hand, is very progressive.
Very. The rate is tied to your income band. It
starts at 8 .75 % for basic rate taxpayers and
goes all the way up to 39 .35 % for the highest
earners. And they've also been slashing the tax
-free allowance for dividends, so it bites almost
everyone now. And finally, the outliers. The
countries that decided the easiest solution is
just to have no dividend tax at all. You've got
some major economies on that list. Brazil is
a big one. Hong Kong, a huge financial center,
has no dividend tax. Iran, Singapore. For a place
like Singapore, that has to be a deliberate strategy.
Oh, it's 100 % a strategic decision to be competitive.
By having no dividend tax, you make your country
an incredibly attractive place to set up a corporate
headquarters or manage capital. It's a policy
that prioritizes attracting global capital flows
over collecting that specific stream of domestic
revenue. The range is just staggering from zero
in Singapore to complex integration in Australia
to what is effectively aggressive double taxation
in South Korea. It proves this is a strategic
lever that governments pull. It absolutely is.
The policy choice a country makes really reveals
its core economic goals. So let's try to wrap
this all up. We started with what seemed like
a simple tax, but it opens up this huge unresolved
conflict. The dividend tax is both a legal necessity
to make corporations pay their dues and an economic
distortion that punishes investment. And that
tension is still there. All these different global
policies are just different attempts to manage
that friction. There's no one right answer. And
the American story shows that policy is just
constantly in flux, leading to the incredibly
complex system we have today. And we saw with
the French study that even the data we use to
make these huge decisions can be unstable. We're
often navigating by theory as much as by hard
evidence. Which leaves us with a final thought
for you, our listener. We've laid out the two
camps, the people who say the tax is destructive
and should be eliminated, and the people who
say it's a necessary price for the privilege
of limited liability. And we've seen that the
global trend seems to be moving towards either
neutrality or integration to try and reduce those
economic distortions. So with that in mind, here's
the question for you. If you were in charge,
how would you solve this? Would you prioritize
economic efficiency and lower the tax on capital,
even if it looks like a giveaway to the wealthy?
Or would you maintain a strong second tax to
ensure that the huge benefit of limited liability
always has a price tag attached? Which solution
do you think best balances the legal fiction
and the economic reality of a corporation today?
It's probably the biggest unanswered question
in corporate finance. And that's all the time
we have for this deep dive. Thanks for joining
us. We'll see you on the next one.