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Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 9b: Dividend Taxation ECON551: Lecture 9b 1

Agenda 1. Overview 2. Different ways of taxing dividends 3. Theories of dividend taxation 4. Evidence: Auerbach and Hassett; Chetty and Saez ECON551: Lecture 9b 2

Overview Last lecture, we talked about different ways of measuring corporate profits. But, once firms generate profit, what should be done — how get that value back to those who provided capital?  Pay bond or bank loan interest if you borrowed money to fund the company.  Pay dividends to shareholders if you raised funds by selling shares.  Buy back shares with the profit. (Should induce capital gain to shareholders.) We will focus on the 2 nd of these methods — paying dividends. There are two distinct questions that can be asked 1. Do existing shareholders care which method is used? 2. Do ongoing firm investment decisions depend on taxation / is cost of capital affected? ECON551: Lecture 9b 3

Accounting for dividends Before getting into the math and the theory , let’s review quickly how the accounting works. Item Amount Revenue 100 Cost of Goods Sold 60 Operating Income 40 Interest payments 10 Profit 30 CIT 30% 9 After-tax profit 21 Dividends 15 Retained earnings 6 So, the basic point is that dividends will be coming out of after-tax profits. That means that any tax on dividend incomes will be on funds that have already paid corporate taxes. ECON551: Lecture 9b 4

Dividend Tax Credit Example British Columbia 2018 Capital Wages/ rate gains interest Dividends Corporate profit before tax $ 100.00 $ 100.00 $ 100.00 Corporate tax paid 27% $ 27.00 $ 27.00 Amount available for distribution $ 73.00 $ 100.00 $ 73.00 dividend gross up 138% $ 100.74 capital gain inclusion 50% $ 36.50 taxable personal income $ 36.50 $ 100.00 $ 100.74 Personal income tax (BC+FED) 49.90% $ 18.21 $ 49.90 $ 50.27 Dividend tax credit (BC+FED) 25.02% $ 25.21 personal taxes paid $ 18.21 $ 49.90 $ 25.06 total taxes paid $ 45.21 $ 49.90 $ 52.06 What is the tax from ‘profit to pocket’? ECON551: Lecture 9b 5

90% Total Taxation of $1 of Pre-Tax Corporate Earnings Distributed Three Different Ways British Columbia 70% 50% Dividends 30% Wage/Interest Prepared by: Kevin Milligan, Vancouver School of Economics Capital Gains Gap: Dividends less Interest Gap: Dividends less Capital Gains 10% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 -10% ECON551: Lecture 9b 6

Trends in dividend income: dollar value of dividend income Source: CRA Income Statistics ECON551: Lecture 9b 7

Trends in dividend income: proportion with any dividend income Source: CRA Income Statistics ECON551: Lecture 9b 8

Trends in dividend income: share of total income Source: CRA Income Statistics ECON551: Lecture 9b 9

Agenda 1. Overview 2. Different ways of taxing dividends 3. Theories of dividend taxation 4. Evidence: Auerbach and Hassett; Chetty and Saez ECON551: Lecture 9b 10

Taxation of dividend income First, we’ll talk about how dividends are actually taxed in Canada and other countries. After that, we’ll take a look at the different theories of dividend taxation. Finally, we’ll look at some recent empirical evidence on dividends that might help us to distinguish between the theories. Notation τ d dividend tax rate τ c corporate tax rate τ p personal tax rate τ g accrual-equivalent capital gains tax rate Two main ways dividends are treated:  Classical systems  Integrated systems Let’s dig in… ECON551: Lecture 9b 11

Classical Dividend Taxation In classical systems, dividends are taxed as regular income in the hands of dividend recipients.  No recognition is offered for the fact that taxes were already paid at the corporate level.  So, for $1 of pre-tax earnings, the shareholder would receive: (1 − 𝜐 𝑑 )(1 − 𝜐 𝑒 ) One argument against this method:  Funds are subject to ‘double taxation’. Q: Should double taxation concern us? Q: Should dividends face higher or lower taxation than personal income? ECON551: Lecture 9b 12

Integrated Dividend Taxation Many countries attempt to integrate the corporate and personal tax systems. Why?  Schanz-Haig-Simons comprehensive measure of income: include all $ equally.  If you’re going to do this, may need to recognize taxes paid at the corporate level. Aim might be to find a 𝜐 𝑒 such that the following holds: (1 − 𝜐 𝑑 )(1 − 𝜐 𝑒 ) = (1 − 𝜐 𝑞 ). If this can be done, interest income (exempt at corporate level; taxed at 𝜐 𝑞 at personal level) receives same tax treatment as dividend income. This all depends on the marginal dividend recipient being a taxable Canadian taxfiler.  Pension funds and other tax-exempts?  International capital market integration? (Boadway and Bruce 1992) ECON551: Lecture 9b 13

Three ways to integrate personal-corporate taxes: 1. Complete integration: Personal taxation entirely accounts for the taxes paid (or not) at the corporate level.  This can get complicated, as firms might have losses, loss carry- forwards, or could be based in different countries.  Taiwan, Australia (franking), and others do this. Corporate fiscal year lines up with personal fiscal year — this makes it easier. 2. Notional integration: Takes ‘benchmark’ corporate tax rate and provides relief based on notional rather than actual corporate taxes.  Canada does this.  Trouble if the chosen benchmark starts to deviate from reality. o E.g. over-integration when firm is not taxable but shareholders still get DTC. ECON551: Lecture 9b 14

Three ways to integrate personal-corporate taxes: 3. Split-rate integration: Tax applied at flat rate to dividend income.  In Germany, rate is 25%.  Common in Europe (EU non-discrimination); Australia almost went this way recently too…  US has lower, but not flat, tax schedule for dividends. ECON551: Lecture 9b 15

ECON551: Lecture 9b 16

Combined Corporate+Personal rates in OECD: OECD Publication: “ Taxation of Dividend, Interest, and Capital Gain Income ” http://dx.doi.org/10.1787/5k3wh96w246k-en ECON551: Lecture 9b 17

How Dividends are Taxed in Canada: Canada uses a ‘gross up and credit’ system.  Korea uses similar method  Australia and New Zealand also do some grossing up.  This is becoming antiquated… Basic idea: ‘undo’ corporate taxation and ‘re - tax’ at personal level.  Give a credit approximately equal to corporate tax paid.  Gross up the income to a notional amount to reflect pre-corporate tax income.  Apply personal tax rate to the grossed-up amount. ECON551: Lecture 9b 18

How Dividends are Taxed in Canada: Consider the following situation: Y in corporate income is available for distribution as a dividend. After paying corporate taxes, the following amount D is left: 𝐸 = 𝑍(1 − 𝜐 𝑑 ) with Yτ c paid in taxes at the corporate level. At the personal level, let’s imagine that the gross up rate is g and the dividend tax credit is d times the grossed up amount. This leaves personal taxes to look like this: 𝜐 𝑞 𝐸𝑕 − 𝑒𝐸𝑕 Total taxes paid at the corporate and personal level is therefore: 𝑍𝜐 𝑑 + 𝜐 𝑞 𝐸𝑕 − 𝑒𝐸𝑕 ECON551: Lecture 9b 19

How Dividends are Taxed in Canada: 1 Let’s assume that the government chooses to set 𝑒 = 𝜐 𝑑 and 𝑕 = 1−𝜐 𝑑 . The total tax paid now looks like this: 1 1 1 𝑍𝜐 𝑑 + 𝜐 𝑞 𝐸𝑕 − 𝑒𝐸𝑕 = 𝑍𝜐 𝑑 + 𝜐 𝑞 𝐸 − 𝜐 𝑑 𝐸 = 𝑍𝜐 𝑑 + (𝜐 𝑞 − 𝜐 𝑑 )𝐸 1 − 𝜐 𝑑 1 − 𝜐 𝑑 1 − 𝜐 𝑑 Substituting in the definition of D leads us to the final step: 1 𝑍𝜐 𝑑 + (𝜐 𝑞 − 𝜐 𝑑 )𝑍(1 − 𝜐 𝑑 ) = 𝑍𝜐 𝑞 1 − 𝜐 𝑑 In other words, the corporate income is effectively taxed at the personal tax rate. ECON551: Lecture 9b 20

Comments on Canada’s Gross -up and Credit:  When this works, income is taxed the same whether as interest, personal income, or dividends, there is no bias in the form of corporate organization (incorporated or not) or corporate finance (through bonds or equity).  What 𝜐 𝑑 to use? Two issues: o Canadian-controlled private corporations (CCPCs) have preferential tax rate. o Provinces have different corporate tax rates. Need to do it separately by province.  Who gets to claim the d ? o What about tax-exempts such as RRSPs or pension funds? o What about low income earners / non-taxable returns? o What about foreigners? What about dividends from foreign firms?  What about firms that suffer losses? We end up with over-integration!  Given opportunities for tax-exempt investing (RRSP, TFSA), why not just replace this with flat rate reflecting top tax bracket full integration level? ECON551: Lecture 9b 21

Agenda 1. Overview 2. Different ways of taxing dividends 3. Theories of dividend taxation 4. Evidence: Auerbach and Hassett; Chetty and Saez ECON551: Lecture 9b 22