Order Code RL31597
Report for Congress
Received through the CRS Web
The Taxation of Dividend Income:
An Overview and Economic
Analysis of the Issues
Updated May 15, 2003
Gregg A. Esenwein
Specialist in Public Finance
Government and Finance Division
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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The Taxation of Dividend Income:
An Overview and Economic Analysis of the Issues
Summary
The recent downturn in the stock market has prompted renewed interest in tax
relief for income from corporate dividends, in part as a method of stimulating the
economy. It is also sometimes argued that corporate shareholders are unfairly taxed
twice on their corporate earnings, once by the corporate tax and again at the
individual level, and that these shareholders are disproportionately represented by the
elderly. Critics of dividend tax relief cite concerns about large revenue costs and
concerns that tax benefits go to well-off taxpayers.
Using dividend tax reductions to stimulate the economy is unlikely to be very
effective because, unlike direct government spending or tax cuts for lower and
moderate income individuals, it is not as likely to directly increase spending, which
is the most effective way to stimulate the economy. Dividend tax reductions that
increase demand for corporate stock, while possibly boosting market values and
spending out of wealth, would also decrease consumption spending or shift funds
from bonds that could raise interest rates, both limiting any expansionary effects.
Economists have traditionally criticized the current tax system, which imposes
both a corporate and individual income tax, for creating distortions in the allocation
of the capital stock that can be large relative to revenue raised. Economic analysis,
however, finds that the unfairness argument lacks justification because behavioral
responses cause the true burden of the corporate tax to be spread to other income
(based on most economic analysis, to all capital income). Most analysis also
suggests that the reduction in the additional tax paid on corporate equity investments
would tend to benefit higher income individuals.
A major barrier to reducing the double tax is the significant revenue loss
associated with almost any proposal. Rough order-of-magnitude calculations suggest
that dividend deductions by firms could result in annual revenue losses well in excess
of $100 billion per year, and dividend exclusions at the individual level could cost
about $25 billion per year. The discrepancy between the two costs reflects largely
the small share of dividends that are actually subject to individual tax (about a third):
most of the revenue cost of a dividend deduction for firms would be associated with
entities that do not pay the individual dividend tax (because they are held by tax
exempt pensions, individual retirement accounts, life insurance companies, and
foreigners). Costs could be reduced with a partial exclusion or capped exclusion.
Corporate tax integration has been studied many times. Efficiency gains should
be considered in the light of revenue needs and distributional effects. The revenue
cost could be reduced to a few billion dollars by a capped exclusion (such as the $400
exclusion in previous law). Such a proposal would not have any of the economic
efficiency effects, however; rather it would merely be a windfall for relatively well-
off taxpayers. Exclusions of small amounts of passive earnings are sometimes
proposed based on eliminating the need to file certain tax schedules, but such a small
exclusion would only reduce filing requirements significantly if it included interest
as well as dividends. This report will be updated to reflect legislative developments.

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Contents
History of Dividend Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Macroeconomic Impacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Issues of Equity and Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Dividend Taxation, Economic Efficiency, and Saving . . . . . . . . . . . . . . . . . . . . . 9
Administrative and Other Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Methods of Integration and Dividend Relief and Their Costs . . . . . . . . . . . . . . . 11
Full Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Dividend Relief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
List of Tables
Table 1: Dividends by Income Class, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Table 2: Distribution of Income: Capital, Labor and Total . . . . . . . . . . . . . . . . . . 8

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The Taxation of Dividend Income:
An Overview and Economic Analysis
of the Issues
The recent downturn in the stock market has prompted renewed interest in tax
relief for income from corporate dividends. President Bush had expressed interest
in providing tax reductions for income from corporate dividends as part of a plan that
would provide economic stimulus by increasing stock market values during an
August economic summit. The President has proposed a plan for eliminating
individual taxes on dividends (and taxes on capital gains arising from retained
earnings) as the centerpiece of his $674 billion (over ten years) stimulus plan: the
dividend proposal accounts for $364 billion of the total. In early May 2003, the
House adopted H.R. 2 which would provide for a 15% maximum tax rate on both
dividend and capital gains income. The Senate is also considering dividend tax
reductions as part of its tax reconciliation package.
It is sometimes argued that corporate shareholders are unfairly taxed twice on
their corporate earnings. First, corporate profits are taxed at the corporate level
under the corporate income tax and then, when corporate profits are distributed as
dividends to shareholders, they are taxed under the individual income tax. Concern
has also been expressed about the effects of the current tax treatment of dividend
income on the elderly.
An analysis of the taxation of dividend income requires an understanding of the
relationship between the individual and corporate income taxes. The corporate
income tax actually pre-dates the individual income tax and has always been imposed
as a separate tax. As a result, income from corporate equity investments is subject
to higher tax rates than income from other investments.
Economists have frequently criticized the current tax system, which imposes
both a corporate and individual income tax, for creating inefficiencies in the
allocation of the capital stock. Economists, however, generally reject the unfairness
argument because economic models suggest that behavioral responses cause the true
burden of the corporate tax to be spread to other income (based on most analysis, to
all capital income). Studies of how to integrate the individual and corporate income
taxes have occurred with regular frequency over the years. However, the corporate
income tax raises significant amounts of revenue and adds progressivity to the federal
tax system. Hence, proposals for full or partial (dividend relief) integration of the
corporate and individual income taxes have significant revenue and distributional
consequences.
This report begins with a brief history of the tax treatment of dividend income.
Next it discusses the effectiveness of dividend relief for stimulating the economy.

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CRS-2
The report then turns to the more traditional issues surrounding corporate tax
integration and dividend relief: equity and distributional issues, economic
efficiency, administrative issues, and the revenue costs for alternative relief
proposals.
History of Dividend Taxation
The modern corporate income tax came into being in 1909 as part of the Payne-
Aldrich Tariff Act. The tax was set at 1% of net income over $5,000. Net income
included dividends paid to stockholders.
The modern individual income tax came into being in 1913 as Section II of the
Underwood-Simmons Tariff Act. It imposed a 1% tax on the net income of citizens
and residents of the United States (the 1% levy was referred to as the normal tax).
In addition, the 1913 Act levied an additional tax or surtax on an individual’s net
income in excess of $20,000. The surtax rates ranged from 1% to 6%.
For purposes of the normal tax, net income did not include dividends paid from
the net earnings of corporations subject to the corporate tax. However, dividend
income was included in an individual’s net income for purposes of computing the
surtax.
The Revenue Act of 1936 ( sometimes referred to as the Undistributed Profits
Tax Act) made significant changes in the tax treatment of dividend income. First,
corporate dividends paid to individuals were subject to both the normal individual
income tax and the surtax. Second, the Act imposed a new surtax on the
undistributed net income of corporations. The new corporate surtax consisted of five
graduated rates ranging from 7% to 27%.
The 1936 Act was designed to prevent what was considered a “leakage” in the
individual income tax system. The tax rate on corporate income was lower than the
individual surtax rates. Corporations could reduce the net tax on corporate source
income by retaining earnings rather than paying them out to stockholders as
dividends (where they would be subject to the surtax). This was considered a tax
avoidance scheme for upper income taxpayers and the 1936 Act was imposed as a
means of forcing corporations to pay out their earnings as dividends where they could
be taxed to the individual stockholders.
The 1936 Act was vigorously opposed by corporate interests as a detriment to
investment and growth. The Revenue Act of 1938 essentially repealed the tax on
undistributed corporate profits. It significantly reduced the surtax rate structure on
undistributed profits and applied the surtax to corporations with net incomes over
$25,000. Moreover, the surtax was applicable only for calender years 1938 and
1939, after which it expired.
From 1939 until 1954, there was no special corporate or individual income tax
treatment of dividend income. The 1954 Act which recodified the tax (the Internal
Revenue Code of 1954) introduced a new dividend exclusion for individuals. For
married couples, each spouse could exclude the first $50 of dividend income received

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CRS-3
with respect to stock owned by that spouse. Hence married couples could have a
maximum exclusion of $100 if both spouses received at least $50 of dividend
income. Single individuals were allowed to exclude up to $50 of dividend income
from taxation. In addition, taxpayers were granted a tax credit equal to 4% of the
dividends they received in excess of the exclusion.
The Revenue Act of 1964 increased the dividend exclusion for married couples
to $100 for each spouse (maximum of $200 per joint return). It also increased the
dividend exclusion to $100 for single individuals. For tax year 1964, it reduced the
dividend tax credit to 2% of dividends received in excess of the exclusion. For tax
years after 1964, the Act repealed the dividend tax credit.
In 1980, the Crude Oil Windfall Profits Tax Act increased the maximum
dividend exclusion for joint returns from $200 to $400 and allowed the exclusion
regardless of which spouse earned the income. For single individuals, the dividend
exclusion was increased from $100 to $200. The 1980 Act also expanded the
exclusion to cover interest income. These changes were to be effective only for tax
years 1981 and 1982. After 1982, the exclusion was to revert to its previous law
levels and coverage ($100 exclusion of dividend income for each individual with
respect to stock owned by that individual).
The Economic Recovery Tax Act of 1981 repealed the interest and dividend
exclusion for tax years beginning after December 31, 1981. However, the 1981 Act
reinstated the previous law exclusion of up to $100 of dividend income from
taxation. For joint returns, a $200 dividend exclusion was allowed without regard
to which spouse actually received the dividend income. This reinstated dividend
exclusion became effective in tax year 1982.
The dividend exclusion for individuals was ultimately repealed by the Tax
Reform Act of 1986, which lowered tax rates and broadened the tax base. The issue
of dividend tax relief resurfaced in the 105th Congress when several bills were
introduced to lower the tax on dividend income. The downturn in the stock market
during 2002 prompted President Bush to include dividend tax reductions in his fiscal
year 2004 stimulus package. In early May 2003, the House adopted H.R. 2 which
would provide for a 15% maximum tax rate on both dividend and capital gains
income. The Senate is also considering dividend tax reductions as part of its tax
reconciliation package.
Macroeconomic Impacts
A principal objective of recent tax proposals is to stimulate the economy in the
short term. Normally a tax benefit favoring individuals with high permanent incomes
(such as a capital gains tax cut, or, as suggested subsequently, dividend relief) is a
relatively ineffective way to stimulate the economy because these individuals tend
to have a higher propensity to save, and it is spending, not saving, that stimulates the
economy. The most effective economic stimulus is one that most closely translates

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dollar for dollar into spending.1 Direct government spending on goods and services
would tend to rank as the most effective, followed by transfers and tax cuts for lower
income individuals (who have a higher propensity to consume).
By these standards, dividend relief tends to rank relatively low as an effective
stimulus. Whether relief is provided directly to corporations or to individuals, the
initial recipients tend to have low short run propensities to spend. Increased cash
flow to corporations would not be expected in theory to increase corporate spending,
especially in a downturn, and empirical evidence, while showing a small positive
relationship between investment spending and cash flow, has significant limitations.
It is therefore reasonable to expect that most of a cut at the corporate level would be
used to pay down debt or paid out as dividends rather than spent immediately. If
relief is provided directly to individuals, the effect will also be limited because
dividends are concentrated among higher income individuals who tend to save more.
One argument that might be made for choosing dividend tax relief as a stimulus
tool is that it would increase the value of the stock market and thus investor
confidence (as well as spending through a wealth effect). Such a link is weaker,
more uncertain, and perhaps more delayed, than a direct stimulus to the economy via
spending increases or cuts in taxes aimed at lower income individuals.
Indeed, it is possible that dividend relief could introduce some contractionary
elements through portfolio shifts. Increased demand for stocks may raise stock
prices, but the translation of this effect into investment stimulus will likely be felt
with a substantial delay. If the increased demand for corporate stock comes at the
expense of investment in noncorporate assets, however, then the negative effects on
investment could occur more quickly than positive ones depending on how fast a
contraction in supply leads to a smaller investment. If investors move funds directly
out of non-corporate business investments, there will be an immediate contraction
in investment spending for those areas where most spending is in new assets. If
funds are moved from debt financed assets, the amount of debt available will fall and
interest rates will rise, which could have a more immediate effect on investment than
a rise in the stock market (and also offset the stock market increase).
Issues of Equity and Distribution
Because of the existence of both a corporate and individual income tax, income
from corporate equity investments is subject to higher tax rates than other
investments. For example, $1 of net corporate income would be subjected to the
corporate tax rate of 35%, generating $0.35 of tax and leaving $0.65 of after-tax
1 For a discussion of the effectiveness of alternative stimulus proposals, see CRS Report
RS21136, Government Spending or Tax Reduction: Which Might Add More Stimulus to the
Economy?, by Marc Labonte; CRS Report RS21126, Tax Cuts and Economic Stimulus: How
Effective are the Alternatives?, by Jane G. Gravelle; CRS Report RL31134, Using Business
Tax Cuts to Stimulate the Economy, by Jane G. Gravelle, and CRS Report RS21014,
Economic Effects of Permanent and Temporary Capital Gains Tax Cuts, by Jane G.
Gravelle.

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CRS-5
income. If the $0.65 of after tax income were paid out as a dividend to a shareholder
in the 25% marginal individual income tax bracket, then an additional $0.1625 of tax
would be owed (25% of $0.65). Hence, the tax rate on $1 of net corporate income
paid out as a dividend would be 51.25% ($0.35 corporate plus $0.1625 individual).
Retained earnings, which increases the value of the firm’s stock, may eventually
be taxed as capital gains income to the shareholder when the shareholder disposes of
the stock. For retained corporate earnings, however, the problem of high tax rates
caused by taxing corporate source income twice is minimized because individual
capital gains tax rates are lower than ordinary income tax rates, taxes on capital gains
income are deferred until the asset is disposed of, and the value of the asset may
benefit from the step-up in basis rules on the death of the taxpayer.
Two distinct equity issues have emerged during the discussion of dividend relief
proposals. The first is the argument that holders of corporate stock are subject to an
“unfair” double tax. This issue is an issue of horizontal equity: are holders of
corporate stock treated unfairly compared to holders of corporate bonds or other
investments? The second is the question of how the tax is distributed across incomes
in the economy, and that depends on whether the burden of the tax is more likely to
be borne by higher income individuals.
These equity issues hinge on the behavioral responses leading to the shifting and
ultimate incidence of the corporate tax. Analyses of the corporate income tax
generally suggest that the extra tax imposed on corporate equity falls on owners of
corporate stock in the short run but is spread to other incomes (either other capital
income or labor income) in the long run. Because returns to corporate equity are
taxed at higher rates than the returns to other assets, capital should migrate out of the
corporate sector (inducing higher rates of return before tax in the corporate sector as
it does so) and into the non-corporate sector (inducing lower rates of return before
tax in the non-corporate sector). This process should continue until after tax returns
are equated in both sectors on a risk-adjusted basis.
This adjustment process means that the equity issue is not one of unfairness to
holders of corporate stock because these individuals pay taxes twice. Even though
dividend recipients are legally obligated to pay more taxes, they are partially
compensated by the higher pre-tax returns that arise from the shifting process and this
partial compensation puts them on an equal footing with investors in other assets.
Thus the “unfairness” problem has already been addressed by market forces.
Rather the equity issue is one of vertical equity: whether the tax on capital
income contributes to the progressivity of the tax system and how desirable that
progressivity is. For that purpose, the crucial issue is where the tax has been shifted.
An extensive literature studying the effects of the corporate tax under many different
circumstances concludes that the burden of the extra tax falls on all capital and that
the tax on corporate equity income can be viewed, for purposes of distributional
analysis, as a tax on all capital income.2
2 The landmark study is Arnold C. Harberger, “The Incidence of the Corporate Income
(continued...)

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CRS-6
There are several caveats to the conclusion that the corporate tax is a tax on all
capital, but none of them support the argument that dividend relief is needed in the
interest of fair treatment to dividend recipients. Indeed, if anything, some arguments
suggest that dividend relief would produce a windfall gain to recipients.
The conclusion that the corporate tax eventually falls on capital income (as
opposed to labor income) rests on the assumption of a fixed capital stock. A decline
in the capital stock as a result of the corporate tax would cause part of the burden to
fall on labor.3 The capital stock could vary for two reasons: savings could change
or capital could exit the country. The first effect is not certain in direction but is
probably small.4 The effect of a corporate tax on capital outflows and incidence
depends on the mobility of capital and the substitutability of products, the degree to
which the tax is a territorial versus a residence-based tax, and the degree to which the
imposition and magnitude of a U.S. corporate tax causes other countries to adopt
similar taxes.5 But even in the case where a territorial tax is assumed and no
response from other countries occurs, empirical measures of capital and product
mobility suggest that the burden still largely falls on capital income.6 Moreover, even
with estimated equity capital outflows, the corporate income tax encourages an
inflow of debt capital and the effects on debt-financed capital, which is more mobile,
could offset, or more than offset, the effects on equity-financed capital.
If firms have market power and are able to earn a return higher than normal,
some fraction of the tax is likely to fall on owners of corporate stock indefinitely.
This tax should appear as a one time decline in prices (when the corporate tax is
imposed). That is, the burden of the corporate tax is not falling on current owners but
is already capitalized in prices. Hence, a cut in taxes would result in a windfall gain.
2 (...continued)
Tax,” Journal of Political Economy, Vol. 70, June 1962. For a review of further
developments, see Jane G. Gravelle, “The Corporate Income Tax: Economic and Policy
Issues,” National Tax Journal, Vol. 48, June 1995.
3 Discussions of the corporate tax sometimes talk of passing the tax forward in prices to
consumers. But the tax actually falls, in an aggregate sense, on capital or labor income. The
relative price of corporate produced goods could go up, but the relative price of
noncorporate goods would fall, with no aggregate effect on real prices. (Nominal prices in
the economy only rise with monetary accommodation and real effects would not occur in
any case). Consumers who prefer corporate goods might be burdened while those who
prefer noncorporate goods would benefit, but there is no aggregate effect on consumers per
se, other than in the underlying effects on labor and capital income.
4 Opposing income and substitution effects make the effect on savings of altering capital
income taxes uncertain. Direct empirical studies of savings elasticities has found mixed
results, but generally report small elasticities that can be positive or negative. See Eric
Engen, Jane Gravelle, and Kent Smetters, “Dynamic Tax Models: Why They Do the Things
They Do?,” National Tax Journal, Vol. 50, Sept. 1997.
5 A residence-based tax applies to all capital owned by U.S. residents regardless of where
invested, while a territorial tax applies depending on the location of investment. The current
corporate income tax is a mixture of the two.
6 See Kent Smetters and Jane G. Gravelle. “The Incidence of the Corporate Tax in an
Open Economy,” National Bureau of Economic Research Working Paper 8280, May 2001.

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CRS-7
One theory of corporate tax incidence argues that all dividend taxes are
capitalized in asset values, and in that case, the burden of the normal tax on dividends
is also a one-time windfall tax, on owners of corporate stock, with no current
consequences. This theory, called the “new view” relies, however, on the inability
of firms to repurchase their own shares, which is not restrained in the U.S. tax system
(but was in the British tax system when this theory was first introduced by a British
economist).
Table 1 shows data on the distribution of dividends and Table 2 shows the
distribution of capital income in general. Both show significant concentration
among higher income individuals. Over 40% of dividends are received by the top
2% of returns (incomes in excess of $200,000) with almost 80% of dividends
received by the top quarter (incomes in excess of $50,000).
Table 1: Dividends by Income Class, 1999
Adjusted Gross Percent of
Percent of
Average
Fraction of Average
Income
Returns in
Dividends in Dividends
Returns
Dividends
($thousands)
Each Class
Each Class
with
for returns
Dividends
with
Dividends
none
0.8
0.9
$1,147
28
$4,158
under 5
10.5
0.9
93
15
585
5-10
10.2
1.3
136
12
1,189
10-15
9.7
1.9
205
13
1,626
15-20
9.3
2.3
265
14
1,943
20-25
7.8
2.0
267
14
1,876
25-30
6.6
2.1
341
17
2,068
30-40
10.5
4.9
488
20
2,436
40-50
7.8
4.5
607
27
2,262
50-75
13.2
11.6
926
37
2,536
75-100
6.1
8.7
1,479
52
2,870
100-200
5.6
17.8
3,350
67
4,982
200-500
1.5
14.6
10,417
85
12,276
500-1000
0.3
7.3
27,923
93
30,178
1000+
0.2
19.0
123,768
95
130,115
Source: CRS calculations based on Internal Revenue Service Statistics of Income,
Individual Income Tax Returns, 1999.

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Table 2 shows that about 30% of capital income in general is received by the
top 1% of individuals and about 73% of capital income is received by the top 20%.7
Thus, under either short run or long run measures, dividend taxes are borne by higher
income individuals.
Table 2: Distribution of Income: Capital, Labor and Total

Population
Percentage of
Percentage of
Percentage of
Share
Capital Income
Labor Income
Total Income
Bottom Quintile
0.7
1.7
2.7
2nd Quintile
4.2
6.3
7.2
3rd Quintile
9.2
12.7
12.6
4th Quintile
15.1
23.6
21.3
Top Quintile
73.2
55.6
56.7
Top 10%
61.5
37.0
40.5
Top 5%
51.8
24.9
29.4
Top 1%
31.6
10.9
14.8
Source: Julie-Anne Cronin, “U.S. Treasury Distributional Methodology,” U.S.
Treasury Department Office of Tax Analysis, OTA Paper, September 1999
It is also sometimes argued that the “double tax” that results from including
dividend income in both the corporate and individual income tax systems tends to
disproportionately affect elderly taxpayers. There is some empirical evidence to
suggest that the elderly tend to hold investments in less risky corporate assets and that
these assets tend to pay higher dividends than other investments. However, as
pointed out earlier in this report, economic analysis rejects the unfairness argument
in general because behavioral responses cause the true burden of the corporate tax
burden to be spread to all capital income. The empirical evidence also shows that in
2000, only 21% of those individuals aged 65 years or older actually received
dividend income. Interest income, which was received by over 58% of this age
group, was a much more significant source of capital income for individuals aged 65
years or older. Hence, the concern that including dividend income in the individual
income tax disproportionately affects the elderly does not appear to be supported by
either economic theory or the empirical evidence.
7 The differences in these distributions may reflect the income measure rather than
indicating that dividends are less concentrated towards higher income individuals. It is
always possible that some returns with low adjusted gross incomes are really higher income
individuals with large discrepancies between economic and tax basis incomes, which might
explain why the bottom 20% receive 3% of dividends but less than 1% of capital income.

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Dividend Taxation, Economic Efficiency, and Saving
Taxes on dividends (and on capital gains that reflect already taxed retained
earnings) result in a heavier taxation of corporate equity capital than is the case for
debt-financed corporate investment or for noncorporate investment. All equity
investments in business assets are taxed more heavily than investments in owner-
occupied housing, but the tax is greater in the case of corporate equity.
These differentials in tax burdens create a distortion that favors noncorporate
investment over corporate investment. Taking into account treatment of debt (which
is deducted by the firm and taxed to the lender), corporate investment is taxed at
about twice the rate of noncorporate investment. The system also favors debt finance
over equity, and retained earnings over dividends. Moreover, because part of the
personal tax is collected as a capital gains tax, the system contributes to a lock-in
effect for assets that discourages the sale of stocks. It is on these grounds that many
economists criticize a separate corporate tax.
Additional taxes also could have effects on savings responses, although the
empirical evidence suggests that taxes on capital income have a small effect that can
be either positive or negative. (Theoretically an increase in tax burdens can decrease
or increase savings because of offsetting income and substitution effects.) It is also
possible that dividend relief proposals would reduce savings because of the increased
incentive to pay out dividends and the possibility that such actions would lead to less
savings. But it is not the savings effect per se, but the distortion in choice that is
costly in an efficiency sense.8

The loss in efficiency in the economy due to the corporate tax has been
estimated at various levels depending on the model used, but may be quite large
compared to the revenue the tax produces. For example, the Treasury integration
study reported full integration to result in an efficiency gain of between 0.13 and
0.73% of consumption depending on the model and whether revenues were replaced.9
This share amounts to $12 billion to $67 billion in 2000 (before the recession began),
at a time when corporate tax revenues were close to $200 billion.10 However, more
limited forms of relief would result in smaller gains. For example, a dividend
exclusion at the individual level (which would eliminate the individual tax) would
produce about $10 billion to $48 billion efficiency gain; a dividend credit designed
to eliminate the corporate level tax and retain the individual level would result in
slightly larger efficiency gains falling between full integration and dividend
8 Measuring the efficiency is complicated by issues of how revenue is to be replaced if the
tax is repealed. Assuming a fixed level of revenue, the efficiency effects depend on how the
distortions arising from capital compare to other distortions that may be larger under
different tax systems.
9 See U.S. Department of the Treasury, Integration of the Individual and Corporate Tax
Systems, Taxing Business Income Once (1992). See also Jane G. Gravelle, The Economic
Effects of Taxing Capital Income, Cambridge, MIT Press, 1994.
10 The net collection from the additional corporate tax would be somewhat smaller
because additional income from the lower tax is subject to individual tax.

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exclusion. A dividend deduction at the firm level would probably produce gains of
similar magnitude.
Only about a third of dividends actually show up on individual income tax
returns as taxable dividends. (The amount potentially subject to tax would be
somewhat higher if dividends paid to trusts are included). The growth of pension and
IRA funds over the past few years and the increasing investment of those funds in the
stock market may have diminished the degree of double taxation (since these assets
are subject to zero tax rates). These non taxable forms of investment may be subject
to different distortionary effects: non-corporate equity investment may not be a
feasible alternative for these institutional investors, there is no incentive for these
investors to prefer retentions to dividends, and no lock-in effect. The total tax burden
is smaller, as well, which reduces the savings distortion. At the same time, the
distortions between equity and debt may actually be larger, since they are not
moderated by the more favorable treatment of capital gains income (relative to
interest as well as dividends) under the individual income tax. (These nontaxable
forms were not treated as affecting the margin in the above estimates.)
Administrative and Other Issues
There is some agreement that many forms of corporate tax integration or
dividend relief would complicate tax administration. Other forms would simplify it.
Dividend exclusions would be relatively easy and would simplify tax filing, but
certain forms of dividend relief that are designed to eliminate the corporate level tax
(rather than the individual level tax) could add to tax administration problems. For
example, shareholder credits would require a gross-up and credit of the dividend
taxes paid at the corporate level, a more complicated revision.
An administrative argument for integrating the corporate income tax is the fact
that many types of firms can now take advantage of many of the benefits of
incorporation without paying the tax. These types of firms include Subchapter S
corporations, LLC’s, and limited partnerships.11 These forms of business
organization complicate tax collections, and their expansion may be of some
administrative concern. Nevertheless, they remain a very small part of business
activity and other measures could be taken to limit their growth if needed.
An important potential complication of certain types of revisions is how to treat
preferences. For example, firms receive a variety of tax benefits, which reduce their
effective tax rate below their statutory rate. Should firms get a deduction for the
dividend at the statutory tax rate, while having profits taxed at a lower effective tax
rate? Many people think they should not, but dealing with preferences (by allocating
them between taxed retained earnings and nontaxable dividend deductions) is a
potential complication of dividend relief. President Bush’s proposal would provide
for such an allocation for preferences.
11 See CRS Report RL31538, Passthrough Organizations Not Taxed as Corporations, by
Jack Taylor, for a description of the various forms of pass-through organizations.

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Proposals that require individual tax relief for retained earnings by adding to
basis, a feature of the President’s proposal, would complicate tax compliance because
annual basis adjustments would have to be tracked.
Methods of Integration and Dividend Relief
and Their Costs
There are several methods of integrating the corporate and individual income
tax. They can be divided into full integration, which covers both dividends and
retained earnings, and dividend relief alone (partial integration). There are three
basic approaches to full integration: taxation on a partnership basis, a credit system
that uses the corporation as a withholding device, and elimination of taxes at the
individual level. A variation of this latter proposal would increase basis by the
amount of retained earnings which would in the very long run tend to eliminate (on
average) the tax on capital gains. A credit system can be designed to allow or not
allow refundable credits of corporate taxes to tax exempt shareholders. There are
also three corresponding dividend relief approaches: deductions by the firm, a credit
system using the corporation as a withholding device, and exclusion of dividends at
the individual level.
These approaches can vary dramatically in their revenue costs, and thus we
report revenue losses for several of the alternatives. Precise revenue effects are
beyond the scope of this analysis and only general magnitudes will be discussed.
Full Integration
The purest approach to full integration would be taxation on a partnership basis,
so that each shareholder pays a tax on his or her pro-rata share of corporate income.
This approach has the effect of eliminating the corporate level tax and taxing
individuals on their shares of corporate income. These methods become complicated
when stocks change hands many times over a year. Shareholder allocation would
lose the entire corporate tax of about $200 billion (at 2000 income levels). However,
individual income would increase by the amount of net corporate income and this
increase would produce additional individual tax revenues which would offset the
cost of lost corporate receipts. Moreover, retained earnings will be taxed currently
in the hands of shareholders at ordinary rates (with the basis of stocks increased
accordingly).
However, according to data in the National Income and Products Accounts,
only about 34% of dividends paid by corporations subject to the U.S. tax appear in
taxable dividends of individuals because of the large shares held in pensions,
individual retirement accounts and by foreigners.12 With an individual tax rate of
12 In 1999, according to National Income and Products Accounts data, corporations paid
$379 billion in dividends ($503.8 billion less $124.5 in intercorporate dividends) while the
IRS reported $129 billion of dividends in adjusted gross income. According to discussions
(continued...)

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CRS-12
30% and 34% of income subject to tax, the effective rate is 10% (0.30 X 0.34) and
the cost would be reduced by $20 billion (0.10 X $200 billion). There is also a gain
from the taxing of previous retained earnings (approximately $95 billion) at the
higher ordinary rates which is about $6 billion).13 Thus the net cost of this form of
integration would be about $174 billion.
The credit approach to integration has the corporation serve as a withholding
agent so that individual shareholders would receive a credit for taxes already paid by
the corporation. An important issue in this approach is whether the credit would be
refundable to tax-exempt investors (including foreign investors and tax exempt
holders, such as pension funds). If the credit is refundable, the cost would be the
same as the shareholder allocation discussed above. However, if the credit is
restricted to taxable shareholders, the cost would be much smaller. Only $68 billion
of corporate taxes (34% of the $200 billion) would be associated with taxable
shareholders and would be lost. However, the full offsets above would still occur
($20 billion of additional taxes on the increase in individual income (0.3 X $68
billion) and the additional offset of around $6 billion (retained earnings taxed at a
higher ordinary rates), for a net total of $42 billion.14
12 (...continued)
with the Bureau of Economic Analysis (BEA), about $157 billion of dividends were
associated with Subchapter S firms not subject to the corporate tax, leaving a total of $222
billion. However, the IRS requires distributions from mutual funds to be reported as
dividends regardless of whether their underlying assets pay interest or dividends. About $54
billion of reported dividends are estimated to be interest, leaving a net total of $75 billion.
Thus, out of total dividends paid by U.S. corporations only 34% showed up on U.S.
individual tax returns. (See Table 8.19, National Income and Product Accounts; the total
includes dividends in personal income and dividends paid to foreign holders, but not
intercorporate dividends. Also see Thae S. Park, “Comparison of BEA Estimates of
Personal Income and IRS Estimates of Adjusted Gross Income,” Survey of Current Business,
Nov. 2000.) Note that dividends do increase eventual pension benefits, but the tax treatment
of pensions (deduction of investment and earnings and tax on benefits) is equivalent to
eliminating the tax on earnings, in this case, dividends.
13 According to data in table 1.19 of the National Income and Product Accounts, domestic
corporate business in 1999 retained $94.5 billion in earnings. If the capital gains rate is
approximately halved because of deferral and step-up in basis at death, it is about 10%, and
the difference between those rates, (20%) multiplied by 34% (to reflect taxable share) and
by $95 billion provides an offset of about $6 billion.
14 The purpose of the credit imputation system is to accomplish the same effect as the
shareholder treatment: to eliminate the corporate level tax and retain the individual tax.
However, a tax continues to be collected at the corporate level and shareholders get a credit.
The mechanism is to impute a grossed up corporate income to the individual and include
that amount in income on which an individual tax would be paid while also taking a credit
for the corporate tax. For example, suppose earnings are $100, the corporate rate is 35%,
and the individual rate is 30%. The after corporate tax earnings are $65 and it is assumed
they are all paid out. However, one does not begin with the $65; rather this $65 is grossed
up by dividing it by one minus the tax rate or (1-0.35), to yield the original $100 (i.e. $65/(1-
.35) equals $100). The individual gets a credit for the corporate tax of 0.35 times grossed
up earnings (or $35), and pays an individual tax of 0.30 on grossed up earnings (or $30).
The excess of the credit over the tax is $5 ($35 minus $30) which, added to the dividend of
$65 provides total earnings of $70.

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CRS-13
A third approach is to eliminate all individual level taxes, which would include
taxes on dividends and an adjustment for capital gains taxes that are collected on
corporate stock. This approach would retain a tax at the corporate level but not at the
individual level. This cost would be highly sensitive to the effects of current stock
market values, but would be less expensive if already accrued gains are not included
or if the capital gains adjustment were to adjust the basis of stock for retained
earnings shares. In the latter case, which is the method used in the President’s
proposal, the cost of excluding dividends would be about $23 billion (0.3 X $75) and
the cost of step-up would be about $3 billion (0.1X $94.5 X0.34). This method
prevents a preference for dividends over retained earnings, but would probably be
quite complicated because it would require taxpayers to keep track of a series of basis
adjustments for each type of stock.

In its 1992 corporate tax integration report, the Treasury also discussed
imposing a tax only at the business level, called the comprehensive business income
tax (CBIT) that would apply to interest and profits. This proposal would allow no
deduction for interest at the firm level (for either corporations or unincorporated
businesses). Individuals would pay no tax on interest or dividends and capital gains
on corporate stock would either be excluded or the basis adjusted to reflect retained
earnings. This approach solves some of the revenue problems associated with
corporate tax integration, but concerns some economists about the possibility of
discouraging investment from abroad because of the lower after tax rates that would
be expected to result. This system would also be applied to non-corporate businesses
(perhaps with an exemption for small business).
Note that the costs estimated in this section should be adjusted to reflect current
income levels, and thus would be higher than those provided.
Dividend Relief
Many difficulties are associated with full integration, in part involving the need
to track and adjust the basis for capital gains arising from retained earnings. When
other countries have integrated their taxes, they have generally done it only with
respect to dividends, a form of partial integration. Dividend relief, however, can
create incentives to distribute profits and does not have efficiency gains as large as
its corresponding full integration method. We calculate revenue costs in this case for
1999, the latest year with data on taxable dividends.
Three methods of dividend relief correspond to the three full integration
methods. Rather than shareholder allocation of all corporate income, a deduction for
dividends can be allowed at the firm level. A credit imputation system confined to
dividends can be allowed instead of a system reflecting all corporate earnings. And
relief at the individual level can be provided through a dividend exclusion.
An apparently simple approach (but one that actually has significant problems
with implementation) is a deduction for dividends. In 1999, corporate dividends
(excluding Subchapter S earnings) were $222 billion. However, the corporation is
likely to pass on as additional dividends to shareholders some or all (even more than
100%) of the tax savings from the dividend deduction. Making the presumption that
the tax is distributed as a dividend, and using a 35% tax rate, we could estimate that

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CRS-14
dividends paid represented $342 billion before tax ($222/(1-0.35)). The direct cost
of the dividend deduction would be $120 billion (0.35 X $342). As with the case of
the partnership treatment, there will be an approximate 10% offset (reflecting the
30% tax rate for the 34% of dividends received by taxable shareholders), for a net
cost of $108 billion.
This number is likely to be overstated because some firms would not have
enough tax liability to absorb the full tax deduction. Some firms pay dividends even
though they have no profits, and some firms pay dividends that exceed their taxable
income because of tax preferences. Moreover, it would be smaller still if preferences
were partially allocated to dividends. That is, an important issue for dividend
deduction is whether dividends should be deducted at the full statutory tax rate, even
though the firm is taking advantage of tax preferences, or whether preferences should
be allocated.
The second method of dividend relief, a dividend credit imputation system, is
the form most commonly used by other countries. The firm pays a tax and the
dividend recipient receives a credit for taxes the firm has paid, based on pre-tax
dividends. As in the case of the full integration with a withholding/credit device,
there is an issue of how to treat tax-exempt shareholders. If the credit is refundable
the costs will be the same as a dividend deduction. If allowed only for taxable
returns, it would affect only 34% of dividends (34% of $120 billion, or $41 billion)
and then have a 30% offset, for a total of about $29 billion. This number, again,
could be overstated because of lack of tax liability for some firms and any allocation
of preferences.
The third and simplest approach is a dividend exclusion, which would eliminate
the individual layer of the tax and cost about $23 billion (0.3 X $75 billion of taxable
dividends (1999 levels)).
The 1992 Treasury study found the exclusion and the credit imputation to be
about of similar size (although the individual top rate was a little lower in 1991), so
their results are consistent with such an assumption. By any standard, however, these
are very large revenue costs. Moreover, they would be larger at current income
levels, although it is difficult to project these costs. Personal dividend income,
however, grew by 24% from 1999 to 2001 and 9% from 2000 to 2001.
Finally, there are proposals to provide a dividend exclusion that is capped at a
certain level, such as the $400 exclusion that was provided historically. While this
provision would be much less costly, it would provide little or no behavioral response
and thus do little to increase investment in corporate equity. The capped exclusion
therefore would have little effect on efficiency or the stock market, the main reasons
for providing benefits, and would essentially be a windfall benefit for holders of
dividends.
We can place an upper bound on an estimate of $400 per return by assuming
every dividend recipient had $400 of dividends. This estimate produces about $4
billion at the 30% tax rate. This estimate would be lower if singles had half the cap,
higher if married couples had twice the cap, and would generally be too high because
some individuals would have smaller amounts of dividends, especially given that

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CRS-15
some dividends are characterized as interest on tax returns. The capped deduction,
however, is clearly a different order of magnitude of costs.
Another way to reduce the revenue cost is to allow an uncapped, but partial
deduction, such as an exclusion for a fraction of dividends received.
As noted earlier, these estimates are not very precise. However, they clearly
illustrate the very large annual cost of almost any type of full scale corporate tax
integration or dividend relief. As one can see by these estimates, limiting the benefits
to dividends, and focusing on taxable shareholders reduces the cost of these
provisions. However, even in the case with the smallest cost, a dividend exclusion,
the cost is still $23 billion at 1999 income levels (which could be considerably larger
today). Limiting the benefits to taxable shareholders may accomplish significant
efficiency gains for each dollar of revenue loss; the power of such a provision in
reducing distortions depends on the extent to which pensions and other plans act as
marginal investors.
Assessment
As indicated in the introduction, the traditional arguments for relieving the
double taxation imposed by the corporate tax are largely related to economic
efficiency, while at least one of the important problems is the potentially large
revenue cost. There is also an issue of who bears the burden, with most analysis
suggesting that the corporate tax contributes to the progressivity of the overall tax
system, an issue of importance for some. Some approaches will reduce
administrative and compliance costs, while others will increase these costs.
These offsetting costs and benefits make the assessment of general corporate tax
integration difficult. There are ways of achieving the efficiency gains that were
considered by the Treasury Department study while still raising the same amount of
revenue and not shifting the tax burden from high to low income individuals. But
they would call for a fairly radical change in the current tax structure or an increase
in top tax rates, changes that might be very difficult. A partial dividend deduction
could be used to scale back the cost but would have more limited efficiency effects.
It appears that there are other, more effective, ways of stimulating the economy than
a dividend deduction.
The analysis suggests that a capped dividend deduction is not likely to achieve
goals of fairness, equity and efficiency. As discussed in the section on distribution,
the double tax does not lead to an “unfair” burden on corporate stockholders. Any
tax on normal return is shifted to capital in general so that, for purposes of measuring
tax burdens, the tax can be considered as a general tax on capital income. A capped
dividend exclusion would be a windfall for the individuals who receive it and have
little or no consequences for marginal investment. Thus it would not have much
effect on allocation, efficiency, or the stock market.

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CRS-16
The capped dividend exclusion might be argued to simplify the tax law, but
since recipients of dividends tend to be higher income and have interest bearing
assets as well, little simplification will result. More simplification would be achieved
by allowing an exclusion that covered interest as well as dividends or limited it to
interest income alone.

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