The Effect of the President’s Dividend Relief Proposal on Corporate Tax Subsidies

The Effect of the President’s Dividend Relief Proposal on Corporate Tax Subsidies

Order Code RL31782
Report for Congress
Received through the CRS Web
The Effect of the President’s Dividend Relief
Proposal on Corporate Tax Subsidies
March 13, 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

The Effect of the President’s Dividend Relief Proposal
on Corporate Tax Subsidies
Summary
A centerpiece of the President’s economic growth package is a provision to
eliminate the “double tax” on corporate earnings, a measure largely aimed at
dividend tax relief. The plan would create excludable dividend amounts (EDAs),
whose purpose would be to identify income that has been subject to the corporate
income tax and allow only that income to be eligible for dividend relief or capital
gains basis adjustment at the individual income tax level.
The Joint Committee on Taxation estimates that the plan would cost $396
billion over fiscal years 2003 to 2013. The design of the President’s dividend relief
proposal would produce some side effects. It could significantly reduce the value of
existing corporate tax subsidies. As a result, it is likely that there will be a decrease
in corporate investment in some subsidized areas.
The largest corporate subsidies include accelerated depreciation, export
subsidies, exclusion of interest on public purpose state/local bonds, and research and
development expenditures. Activities that rely heavily on corporate tax preferences
could be negatively affected. One area that has received attention is low income
housing, which relies heavily on the low income housing credit. Preference
restrictions could also undermine the temporary investment stimulus enacted in 2002.
The mechanics causing these reductions in value are relatively straightforward.
Under current law, the actual tax savings from a corporate tax subsidy are passed
through and taxed at the individual level, whether as dividends or capital gains
income. Under the President’s proposal, the corporate income that generated the tax
subsidy would be passed through and taxed at the individual level.
The rationale for restricting corporate tax preferences in the proposal is not
stated. The efficiency argument that economists use to justify corporate tax
integration is not necessarily consistent with reducing corporate tax benefits. It is
possible that the treatment of corporate preferences was adopted to minimize revenue
loss; such a rationale was used in a 1992 Treasury study of integration.
The reduction in the value of corporate subsidies depends on the value of
preferences relative to the corporation’s income, the corporation’s dividend
distribution policy, and the tax rate of the shareholder. In some circumstances the
reduction in the value of the subsidies could be substantial.
Dividend tax relief could be designed so as to pass through the benefits of any
or all corporate tax preferences. If revenue is an issue, one approach could be to
allow partial exclusions for both dividends and capital gains income which would
eliminate the need to calculate excludable dividend amounts.
This paper provides an economic analysis of the proposal to establish
excludable dividend amounts. It does not track legislative developments and will not
be updated.

Contents
How EDAs Affect Corporate Tax Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Alternative Approaches and Their Effects on Corporate Tax Preferences . . . . . . 5
What Is The Rationale For EDAs? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Effects of EDAs on Incentives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Magnitude of Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Economic Activities Affected . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Possible Revisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
List of Tables
Table 1: Percentage Reduction in Tax Benefits at the Margin,
Taxpayer in the 25% Bracket, for Different Payout Ratios and
Ratios of Tax Benefits to Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Table 2: Percentage Reduction in Tax Benefits at the Margin,
Taxpayer in the 35% Tax Bracket, Different Payout Ratios and
Ratios of Tax Benefits to Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Table 3. Major Tax Subsidies for Corporations . . . . . . . . . . . . . . . . . . . . . . . . . 10

The Effect of the President’s Dividend Relief
Proposal on Corporate Tax Subsidies
A centerpiece of the President’s economic growth package is a provision aimed
at eliminating the “double tax” on corporate dividends.1 The guiding principle of this
proposal is that corporate income should be taxed only once, so if it is taxed at the
corporate level it should not be taxed at the individual level. Thus, the President’s
plan allows corporate income that has been taxed at the corporate level to be tax free
at the individual level. If the previously taxed corporate income is distributed as
dividends, then when the dividends are distributed they would not be subject to tax
at the individual level. If the previously taxed corporate income is retained, then
shareholders would be allowed an adjustment (increase) in the basis of their stock
holdings so that the previously taxed corporate income would not be subject to
individual capital gains taxes when the shareholders sell their corporate stock.
The President’s proposal would significantly reduce the combined taxes
(corporate and individual) on corporate source income. However, the proposal’s
design would produce some side affects. The President’s plan contains a feature
called excludable dividend amounts (EDAs), whose basic purpose would be to
identify income that has been subject to the corporate income tax and allow only that
income to be eligible for dividend relief or basis adjustment at the individual income
tax level. (This proposal has been slightly modified in H.R. 2, a bill incorporating
the President’s tax plan, to allow a carry over of EDAs in excess of dividends.)
The President’s approach would reduce the value of existing corporate tax
subsidies and preferences.
The Joint Committee on Taxation estimates that the President’s plan to
eliminate the double taxation of corporate earnings would cost $396 billion over
fiscal years 2003 to 2013.
The first section of this report explains how these excludable dividend amounts
(EDAs) work and how they affect the value of corporate tax preferences. The second
section of the report details alternative approaches and their effects on corporate tax
subsidies. The next section of the report explores the rationale for EDAs. The final
section concludes with a review of general policy issues, including a discussion of
the general types of corporate tax preferences currently allowed and a discussion of
possible alternative approaches.
1 Background on the “double taxation” issue, the different forms of corporate double tax
relief, and other issues associated with the dividend plan can be found in CRS Report
RL31597, The Taxation of Dividend Income: An Overview and Economic Analysis of the
Issues, by Gregg A. Esenwein and Jane G. Gravelle.

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How EDAs Affect Corporate Tax Preferences
Under the President’s proposal, a corporation would compute an
excludable dividend amount (EDA). A corporation could distribute the EDA to its
shareholders and the shareholders would not have to pay individual federal income
taxes on the distributions. Alternatively, corporations could retain all or some
portion of their EDA, in which case the basis of the shareholders’ corporate stock
would be increased to reflect the fact that a portion of the stock’s value (the
undistributed EDA) had already been subjected to the corporate income tax.
To calculate the EDA, corporations would convert their prior year U.S.
corporate income taxes into an amount that is equivalent to the amount of prior year
corporate income that was taxed at a 35% tax rate. For this calculation, U.S.
corporate income taxes would be calculated on a pre-tax credit basis with respect to
the foreign tax credit and the credit for the corporate alternative minimum tax.
Corporate taxes would be calculated on a post-tax credit basis with respect to all
other tax credits. The following formula shows how a corporation’s EDA would be
determined.
EDA = (Corporate income taxes/.35) - corporate income taxes
For example, if a corporation paid $35 in corporate income taxes in the first
year, then its EDA for the next year would be $65 (($35/.35) - $35). Essentially,
EDAs are designed so that corporate income is taxed only once, at either the
corporate or individual level. If the income is subject to tax at the corporate level
then use of the EDA would ensure that it is not subsequently taxed at the individual
level. (This formula is equivalent to 1.857 times the tax).
A consequence of this approach, however, is that EDAs reduce the value of
corporate tax subsidies. This occurs whether the subsidy takes the form of a
reduction in corporate taxable income or as a credit against corporate income tax
liability. It also occurs whether the EDA is distributed to shareholders or retained
and used to adjust the basis of shareholder stock holdings. The following simplified
examples using tax credits as the corporate tax subsidies show how this effect occurs.
Consider a case under current law where a corporation has $100 of net income.
With a corporate tax rate of 35% the corporation would owe $35 in federal income
taxes on this income. Further assume that the corporation is eligible for a corporate
tax credit of $10. The final tax owed at the corporate level would be $25 ($35 tax
less $10 credit) and the corporation would have $75 in after tax income that it could
distribute to its shareholders.
If the corporation distributed the entire $75 to its shareholders, and, it is
assumed that the average tax rate at the individual level is 25%, then individuals
would pay an additional $18.75 worth of tax on this corporate source income. In
effect, individual income tax is assessed on both the after tax income of the
corporation ($65) and the passed through savings from the corporate tax credit ($10).
The total tax assessed on this $100 of corporate source income at both the corporate

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and individual levels would be $43.75 ($25 of corporate income tax plus $18.75 of
individual income tax).
In the absence of the $10 corporate tax credit, the corporation would have paid
$35 in corporate income taxes and would have been able to distribute only $65 to its
shareholders ($100 income less $35 corporate income taxes). At a 25% tax rate
individuals would have paid $16.25 in individual income taxes on their $65 of
corporate dividends. So, in the absence of the $10 corporate tax credit, the total tax
paid at both the corporate and individual levels on $100 of corporate source income
would have been $51.25 ($35 of corporate income tax plus $16.25 of individual
income tax).
As this example demonstrates, the current law value of the $10 corporate tax
credit is actually $7.50 once the added effect of assessing tax at the individual level
is factored into the equation. Total taxes (both corporate and individual) paid on $100
of corporate source income is $43.75 with the credit versus $51.25 without the credit.
That is, the tax is $7.50 ($51.25 minus $43.75) less with the $10 credit.
Now consider what happens to the value of a $10 corporate tax credit when
EDAs are employed. With a $10 corporate tax credit, a corporation that had $100
of net income would pay $25 in corporate taxes ($100 income at a 35% corporate tax
rate less the $10 credit). The corporation would have $75 in after tax income that it
could distribute to its shareholders. But a portion of this dividend distribution, the
excludable dividend amount (EDA), would not be taxable at the individual level.
Substituting the values from this example into the formula for calculating EDAs
produces:
EDA = ($25/.35) - $25
EDA = $46.43
Hence, of the $75 that the corporation pays out as dividends, only $28.57 ($75
in distributed dividends minus the $46.43 that is excludable ) is subject to tax at the
individual level. Assuming a 25% rate at the individual level, then the taxes owed
at the individual level would be $7.14. The total tax paid at both the corporate and
individual level on this $100 of corporate source income would be $32.14 ($25 in
corporate level taxes plus $7.14 in individual income taxes).
In the absence of the $10 corporate tax credit, the corporation would pay $35 in
corporate income tax on $100 of net income and could distribute $65 in dividends
to its shareholders. Substituting these values into the formula for calculating EDAs
yields:
EDA = ($35/.35) -$35
EDA = $65
The entire $65 in dividend income would be excluded from tax at the individual
level. The total tax paid at both the corporate and individual level on the $100 of net
corporate income would be $35 ($35 at the corporate level and $0 at the individual
level).
Hence, with EDAs the value of the $10 corporate tax credit is only $2.86. Total
taxes (both corporate and individual) paid on $100 of corporate source income is

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$32.14 with the credit versus $35.00 without the credit. The value of the $10 tax
credit falls from $7.50 under current law to $2.86 ($35.00 minus $32.14) under the
President’s proposal. The value of the credit is reduced by almost 62%.
After Tax Value of a $10 Corporate Tax Credit
(Assuming all corporate after tax income distributed to shareholders as
dividends and average shareholder tax rate is 25%)
Current Law
President’s proposal using EDAs
$7.50
$2.86
The mechanics causing these results are relatively straightforward. Under
current law, the actual tax savings from a corporate tax subsidy are passed through
and taxed at the individual level, whether as dividends or capital gains income (the
$10 credit in the examples illustrated above). Under the President’s proposal, the
corporate income that generated the tax subsidy is passed through and taxed at the
individual level ($28.58 which is the corporate tax credit, $10, divided by the
statutory corporate tax rate, 35%). The result is a reduction in the value of the
subsidy.
The percentage reduction in the value of the corporate tax subsidies will depend
on the shareholders’ actual tax rates. If the example above were computed using the
top permanent individual marginal tax rate of 35%, then the value of the corporate
tax credit would fall from $6.50 under current law to $0 under the President’s
proposal, or a 100% reduction. Conversely, if the shareholders were tax exempt
(e.g. corporate stock was held in an IRA) then there would be no reduction in the
value of the corporate subsidies under the President’s plan.
The reduction in the current law value of corporate tax subsides under the
President’s proposal will be less if corporations retain the income in excess of their
EDAs rather than paying it out as dividends to their shareholders. This occurs simply
because the amounts that exceed the EDA that are retained by the corporation are
subject to capital gains tax rates when shareholders sell their corporate stock.
Effective capital gains tax rates are lower than the individual tax rates applicable to
distributed dividend income that exceeds the EDA, because the statutory tax rates on
capital gains are lower, the taxes on capital gains income are deferred until sale of the
asset, and some capital gains are never taxed because they are passed on at death.
The President’s proposal to end the double taxation of corporate source income
is a tax cut. Corporate shareholders will see a significant reduction in their combined
(corporate and individual) income taxes under the President’s plan.
The effects on the value of corporate tax subsidies will also be significant. The
value of all corporate tax subsidies will fall. As a result, it is likely that there will be
a decrease in corporate investment in some subsidized activities.

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Alternative Approaches and Their Effects on
Corporate Tax Preferences
The issue of the pass-through of corporate tax preferences has been discussed
in previous studies of corporate double-tax relief. When proposals to relieve one of
the levels of tax are made (either the corporate or individual level), how the relief is
structured will determine the degree to which corporate tax preferences are preserved.
If the object were to eliminate the corporate level of tax, some methods of
double tax relief would automatically eliminate the benefits of corporate tax
preferences unless special measures were taken to preserve them. For instance,
providing a credit against individual income tax liability to individual shareholders
for corporate taxes paid on their corporate source income would eliminate all of the
benefits of corporate tax preferences.
Providing relief by taxation on a partnership basis, on the other hand, would
have the opposite effect: by eliminating the corporate level tax and reflecting
preferences in the allocable taxable income of the partners (and allocable credits), the
preferences would be preserved. This approach would treat corporate shareholders
the same way as unincorporated businesses are treated under current law.
When the individual level of tax is to be eliminated, there are several approaches
that could be employed. Distributed corporate dividends and capital gains on
corporate stock sales could be excluded from individual taxable income. Such an
approach would preserve the corporate level of tax with all its preferences. It would,
however, be very costly and somewhat inefficient because it would eliminate taxes
on all the accumulated capital gains on existing assets, creating a windfall for
individual stockholders. If the proposal simply excluded dividends, then firms
(especially closely held ones) would be able to pay out dividends, have them
reinvested in the firm (which increases the basis of the stock), and eliminate
accumulated capital gains in that way.
Because of the revenue and windfall gain concerns, most plans for dividend
relief at the individual level of tax have some method of dealing with the problems
of accumulated earnings by restricting either dividend relief or basis adjustments.
There are two approaches that address these concerns, both of which use approaches
similar to EDAs. One passes through corporate tax preferences and one does not.
As illustrated earlier, the current proposal for dividend tax relief using EDAs
does not pass through the full value of corporate tax preferences. In January 1992,
the Treasury Department issued a report on corporate tax integration in which an
approach was proposed that was very similar to the one currently under
consideration. Apparently the reason that approach did not pass through corporate

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tax preferences was because of revenue losses.2 (In fiscal year 2003, corporate tax
subsidies were approximately 65% of total corporate tax revenues.)
However, the Treasury subsequently proposed a dividend relief plan that did
include the passthrough of corporate tax preferences. In this version, which was
proposed by the outgoing George H. W. Bush Administration in December of 1992,
all dividends were excludable from taxation at the individual level, but dividends
paid in excess of amounts deemed non-taxable would reduce the basis of corporate
stock. With such a rule, there is no advantage in paying out past accumulated
earnings as dividends and reinvesting them because any increase in basis would be
offset by the basis reduction rule. These accounts would be the sum of taxable
corporate income plus permanent preferences (such as tax exempt interest) minus
taxes paid before credits.
What Is The Rationale For EDAs?
Aside from revenue concerns, what are the justifications for not providing a
passthrough of preferences? This assessment depends on the rationale for providing
double tax relief in the first place.
Although some have argued for dividend relief on the grounds of fairness
among investors, this argument is not consistent with economic analysis which
suggests that after tax returns are equated, net of risk, by market forces. There is no
need to provide dividend relief to be “fair” to investors in corporate stock (as
opposed to other forms of investment); the market will produce that result left on its
own.
Economic arguments for providing relief to dividends tend to rest on efficiency
grounds: corporate equity investment is subject to higher taxes than non-corporate
investment or debt financed capital, and the resulting misallocation of capital causes
economic inefficiency. Thus, efficiency is the central rationale for considering
dividend relief. Indeed, economic efficiency is stated as the principal rationale for
double tax relief in the Treasury discussion of the President’s dividend tax reduction
proposal.3

It is not clear that the efficiency rationale justifies restrictions on the pass-
through of corporate preferences. Tax preferences will still be available for
2 See Michael Graetz and Alvin C. Warren, “Interaction of the Corporate and Individual
Income Tax: An Introduction to the Issues,” in Integration of the U.S. Corporate and
Individual Income Taxes, Arlington, VA: Tax Analysts, 1998. The Treasury Integration
Study published in January 1992 was quite similar to the current proposal, although it did
not provide benefits for income taxed by foreign governments but not by the U.S. system
(while the current proposal does). In December 1992, the outgoing Bush Administration
proposed a more generous system that basically excluded all dividends and provided
benefits for retained earnings reflecting a broader measure of income.
3 U.S. Department of Treasury. General Explanation of the Administration’s Fiscal 2004
Revenue Proposal, February 2003, p. 11.

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unincorporated businesses. So tax differentials would remain with respect to
preferentially treated income in the corporate versus the non corporate sector.
From an efficiency viewpoint, by choosing to reduce the value of corporate tax
preferences, this approach maintains a differential tax treatment between the
corporate and non-corporate sectors. In fact, the Administration’s proposal actually
further expands tax benefits for small unincorporated businesses by raising the limit
on expensing. So at the same time it is trying to insure that corporate income is
subject to at least one level of tax, other elements of the Administration’s plan
expand opportunities for investments in the non-corporate sector to escape tax
altogether. (The proposal also expands benefits available to corporations, whose
value will be reduced, perhaps substantially, by the EDA approach).
The limit on corporate preference passthrough undermines the incentive effects
of those tax subsidies. If those subsidies were desirable in the first place, it seems
appropriate to continue them in full strength. Of course, the change could improve
overall economic efficiency if corporate tax preferences are undesirable. Still, a more
effective approach would be to repeal the preferences outright.
One rationale may remain and is alluded to in the Treasury analysis. Some tax
reductions arise from tax sheltering activities that are not intentional preferences.
These tax shelters are difficult to detect and prevent. In this case, limiting the
passthrough of preferences may be desirable.
Effects of EDAs on Incentives
Magnitude of Effects
As noted above the reduction in the value of the corporate subsidy depends on
whether dividends are less than or greater than the EDA. The size of the EDA is
itself affected by the size of corporate subsidies. The reduction in subsidy values,
therefore, depend on the tax rate, the pay-out ratio, and the ratio of subsidies to
income, which govern at what payout ratio the dividends will exceed EDA. Table
1 provides calculations of the percentage decrease in the value of the subsidy
depending on payout rate and size of subsidy relative to income in the case of a 25%
tax rate. Table 2 provides the estimates for a 35% rate. (Both assume a capital gains
effective rate of 10%.)
For firms that retain all earnings, the reduction in the value of the subsidy is
approximately 21%. The reduction gets smaller as more dividends are paid out
(because taxes are higher under existing law but there is a constant tax penalty under
the dividend relief proposal). There is a sharp break between the effect on a marginal
dollar of subsidy as dividends begin to exceed the EDA, when the value of additional
dollars of subsidy (holding payout ratios constant) falls substantially. When all after
tax income is paid out as dividends, the reduction in the value of the tax subsidy is
extremely large, and the entire subsidy disappears when the shareholder is in the
same tax bracket as the firm, 35% (Table 2). In that case, what is saved at the
corporate level is repaid as tax at the individual level. Thus, the firms that would be

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most affected by the President’s proposal are those with high payout ratios, those
with significant preferences, and those whose shareholders are in high marginal tax
brackets.
Table 1: Percentage Reduction in Tax Benefits at the Margin,
Taxpayer in the 25% Bracket, for Different Payout Ratios and
Ratios of Tax Benefits to Income
Payout Ratio
C/Y = 0.05
C/Y = 0.10
C/Y = 0.15
C/Y = 0.30
0.0
20.6
20.6
20.6
20.6
0.1
19.3
19.3
19.3
52.5
0.2
17.9
17.9
17.9
53.3
0.3
16.5
16.5
16.5
54.3
0.4
15.0
15.0
55.2
55.2
0.5
13.4
13.4
56.2
56.2
0.6
11.8
11.8
57.3
57.3
0.7
10.2
58.4
58.4
58.4
0.8
59.5
59.5
59.5
59.5
0.9
60.7
60.7
60.7
60.7
1.0
61.9
61.9
61.9
61.9
Source: CRS calculations. See appendix for details.
Table 2: Percentage Reduction in Tax Benefits at the Margin,
Taxpayer in the 35% Tax Bracket, Different Payout Ratios and
Ratios of Tax Benefits to Income
Payout Ratio
C/Y = .05
C/y = .10
C/Y = .15
C/Y = .30
0.0
20.6
20.6
20.6
20.6
0.1
18.4
18.4
18.4
74.3
0.2
16.0
16.0
16.0
76.4
0.3
13.4
13.4
13.4
78.8
0.4
10.7
10.7
10.7
81.3
0.5
7.8
7.8
83.8
83.8
0.6
4.7
86.7
86.7
86.7
0.7
1.6
89.7
89.7
89.7
0.8
92.9
92.9
92.9
92.9
0.9
96.3
96.3
96.3
96.3
1.0
100.0
100.0
100.0
100.0
Source: CRS calculations. See appendix for details.

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Determining a typical effect on behavior is not easy. A significant fraction
(more than half) of stocks are held by taxpayers who would not benefit from the
President’s proposal for double taxation relief, either because they are already tax
exempt (pensions, IRAs, stocks held by non-profits) or because they are not eligible
(foreign shareholders). If all of these taxpayers are weighted together, the effects
would probably be about half of some amount between those in Table 1 and Table
2. If, on the margin however, shareholders are in high marginal income tax brackets,
then the effects could be larger. If corporate managers, who own stock, give
particular weight to their own circumstances, then the effects on incentives could also
be more pronounced.
Economic Activities Affected
What types of economic activities that currently receive subsidies might be most
affected by the reduction in value of preferences? Table 3 lists the largest corporate
tax subsides for fiscal years 2003 through 2007.
By far the largest tax expenditure, $119 billion, was the value of accelerated
depreciation; this cost is particularly large because it reflects the temporary expensing
provision enacted in 2002 to stimulate investment. (Because this benefit is a timing
benefit, with a current loss offset by a future gain, its magnitude is overstated.) The
temporary expensing provision was widely agreed upon to be the most effective way
to stimulate investment;4 in fact, it is possible that the undermining of this provision
could cause the dividend package to be contractionary initially.
Another set of provisions that would be significantly affected are two associated
with export subsidies (exclusion of extraterritorial income and inventory property
source rules) which together total over $55 billion; most economists, however,
would suggest that export subsidies do not add to economic efficiency. Provisions
that economists are more likely to support are those relating to research and
experimentation (tax credit and expensing) which sum to $40 billion.
Also significant are revenue losses from tax exempt interest of state and local
governments, provisions favoring investment abroad and investment in Puerto Rico.
In addition to the variety of provisions listed in the table, many of which are specific
to certain industries, there are many smaller tax subsidies that may affect a smaller
set of activities.
The actual effects on a particular activity will depend on how important tax
preferences are to that activity and how they benefit from the general dividend tax
relief. Except for a possible timing effect, the reduction in preferences on accelerated
depreciation would be more than offset by the general benefit to investment from
relief of double taxation. Similarly, many firms export and would receive benefits
for dividend relief on the taxed portion of export income that offset, or more than
offset, the disincentive from reduction in the value of the preference.
4 See CRS Report RL31134, Using Business Tax Cuts to Stimulate the Economy, by Jane
G. Gravelle.

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Table 3. Major Tax Subsidies for Corporations
(billions of dollars)
Subsidy
Estimated Revenue Cost, Fiscal
Years 2003-2007
Depreciation of equipment in excess of
$119
alternative depreciation system
Exclusion of interest on public purpose
$34
state/local bonds
Inventory property sales source rule exception
$28
Exclusion of extraterritorial income
$27
Expensing of research and experimental
$26
expenditures
Reduced tax rates on 1st $10,000,000 of
$24
corporate income
Deferral of active income of controlled foreign
$24
corporations
Deduction for charitable contributions
$20
Low income housing credit
$16
Tax credit for qualified research expenditures
$14
Deduction of unpaid property loss reserves for
$7
property and casualty insurance companies
Tax credit for Puerto Rico
$5
Source: Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2003-
2007, Dec. 2002.
However, activities where preferences play a large role could experience
significant contractions. One area of preferentially treated activity that has received
some public attention is low income housing. A recent study predicted significant
adverse effects because housing tax credits are a large source of low income housing
finance and are heavily supplied by corporations.5 The study also argued that State
and local government’s ability to provide their share of financing would be adversely
affected by the direct loss of benefits to tax exempt bonds held by corporations, as
well as the general diversion of investment out of tax exempt bonds by individual
investors who shift to corporate stock and by the loss of tax revenue to states that
base their income tax system on the federal income tax base. The analysis concluded
5 Ernst and Young, LLP, The Impact of the Dividend Exclusion Proposal on the Production
of Affordable Housing, Commissioned by the National Council of State Housing Agencies,
Feb. 2003.

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that low-income housing construction would fall by about 35%, although apparently
the Treasury questions that estimate.6
In general, subsidized activities earn a lower pre-tax return and the reduction in
the subsidy reduces the scope of investment projects which are viable. In some
cases, corporations participate in a broader market where reduced activity may not
materially alter those returns (or may not alter them enough to make investment
viable). An example of this activity is tax exempt bonds, where both individuals and
corporations invest, and which pay lower interest rates because they are not taxable.
In such a market, it is possible that corporate participants would withdraw entirely.

Possible Revisions
The President’s dividend relief proposal could be revised to eliminate its
adverse impact on corporate tax subsidies. If there is a desire to preserve the benefits
of particular credits, then one could base the EDA on tax liability prior to credits. In
fact, all legislated subsidies could be passed through, which would result only in a
reduction in the value of unintended tax benefits. There are also ways to pass
through corporate preferences in general to the individual level (as was done in the
December 1992 proposal).
If revenue is an issue, then it might be possible to provide a partial relief
provision without restricting preference passthrough, and indeed without setting up
accounts at all. For example, if dividends were taxed at least as much as capital
gains, then there would be no way to save revenue by paying out and reinvesting
dividends. One possibility would be a flat 50% exclusion for both dividends and
capital gains. Capital gains are already close to a 50% exclusion for the top tax
bracket (and gains are heavily concentrated in these brackets), so that a large revenue
loss might not result from the capital gains exclusion.
Appendix
This appendix formalizes the treatment of preferences under the EDA and
explains how the treatment reduces the value of preferences. In this example, we
capture all tax preferences that deviate from economic income as a credit equivalent,
c. This amount may actually be a credit, or it can be construed as the tax saving from
a deduction or exclusion.
Under current law, after tax income which can be either paid to shareholders as
dividends or retained for reinvestment is:
(1) After Tax Corporate Income = Y(1-u) +c
where Y is economic income before tax, u is the corporate tax rate, and c is the
credit.
6 Tax Analysts. “Taxwriters Examine Effect of Dividend Exclusion on Housing, Retirement
Saving.” Tax Notes Today, March 7, 2003.

CRS-12
After tax accrued income (either retained or distributed) to shareholders is:
(2) After Tax Individual Income = Y(1-u)+c - xt(Y(1-u)+c) - (1-x)t (Y(1-u)+c)
g
where x is the share of earnings paid out as dividends, t is the tax rate of the
shareholder and t is the accrual equivalent tax on capital gains (a rate that takes into
g
account that some gains tax will never be paid because stock is held until death). For
those above the 15% rate, the tax on capital gains is 20% if held for a year and 18%
if held for five years. Typically, the tax rate is roughly halved to reflect the fraction
of gain that is never taxed and the advantage of deferring the tax on that which is.
In the calculations below, we use a rate of 10%.
If we separate out the terms associated with preferences, or c, we see that a
credit, other things equal, increases after tax income by:
(3) Increase in income due to credit = c(1-xt-(1-x)t )
g
As this formula indicates under the present law treatment individual shareholder
taxes are effectively paid on the value of the tax credit, an effect that occurs because
of the normal reduction in shareholder tax that occurs when the firm incurs additional
costs due to paying taxes.
Under the new system, the EDA is defined as:
(4) EDA = T/u -T = T(1-u)/u
Since:
(5) T =( uY-c),
one can rewrite (4) as:
(6) EDA = (uY-c)(1-u)/u = Y(1-u) + c - c/u
The EDA is after tax income reduced by the income excluded from tax due to
the credit (c/u).
With the new system, there are two cases, one where dividends are less than the
EDA and one where they are more than the EDA.
Case I. x(Y(1-u)+c) < Y(1-u) +c -c/u
In this case,
(7) After tax income = Y(1-u)+c - xt(Y(1-u)+c) - (1-x)t (Y(1-u)+c) +tD+t (EDA-D)
g
g
where D is the level of dividends, equal to x(Y(1-u)+c)
The second and fourth term cancel, and by recombining terms:

CRS-13
(8) After tax income = Y(1-u) +c - t (Y(1-u) +c - EDA)
g
Or,
(9) After tax income = Y(1-u) + c - t c/u
g
If we isolate the c terms again:
(10) Increase in income due to credit = c (1-t /u)
g
If we compare this amount to the amount in (3) we can see that the value of the
credit falls. Recall that this case only applies when the value of x meets the
conditions for Case I, which by some manipulation, can be expressed as:
(11) x < u(1-u) -(1-u)c/y
u(1-u)+uc/y
At one extreme, if x = 0, the value of the credit under current law is c(1-t ) and the
g
value under the new system is c(1-t /u). With t set at 0.1 and u at 0.35, the value per
g
g
dollar of additional credit is $0.90 in the old system and the value would be $0.71 in
the new system. Note that as long as the distributions fall into case I, the after tax
benefits will be constant under the new system, but it will decline under the old
system as the share paid out as dividends increases. (These calculations apply only
to the margin, as changes in the credit affect the cut-off point between Case 1 and
Case II.
Case II: x(Y(1-u)+c) > Y(1-u) +c -c/u
In this case:
(13) After tax income = Y(1-u)+c - xt(Y(1-u)+c) - (1-x)t (Y(1-u)+c) +tEDA
g
Note that in this case an additional credit results in an additional distribution
taxed partially at the capital gains tax rate and partially at the dividend tax rate, and
also reduces the EDA amount (for a dollar of credit, the account falls by $1/u).
After some manipulation, the value of c can also be expressed as:
(14) After tax value of credit = c(1+(t-t )(1-x) -t/u)
g