Dividend Income Should Be Taxed As Regular Income

Thomas Jefferson was the ultimate enemy of aristocracy. He believed that the danger of an artifical class of elites, based on wealth and birth rather than virtue and talent, entrenching itself in the American republic was one of the greatest threats to the continued survival of the nation. His time in France, where he saw a nobility that paid no taxes while the mass of the people starved, only deepened his hostility. As he said in a letter to John Adams, "The artificial aristocracy is a mischievious ingredient in government, and provision should be made to prevent its ascendancy."

Sadly, Jefferson's worst fears about aristocracy have been realized. To quote the New York Times investigative report David Johnston, in his book Free Lunch, "[I]n 2005, the 300,000 men, women, and children who comprised the top tenth of 1 percent had nearly as much income as all 150 million Americans who make up the economic lower half of our population. Add the income the rich are not required to report and those 300,000 made more than the 150 million."

America likes to think of itself as the great land of opportunity, a true meritocracy where one's prosperity depends entirely on one's abilities and their willingness to work hard. This may have been true at the time of the nation's founding, and perhaps event for some time thereafter. But in the early 21st Century, the American economy has undeniably become rigged in favor of the rich and powerful. And it's not just because the rich and powerful have more access to politicians, can obtain better lawyers and more easily get into the elite schools. It's also because the American tax system is also rigged in favor of the rich at the expense of the poor and the middle-class.

This can most clearly be seen when looking at the dividend tax. The rich earn a much greater share of their wealth from dividends on investments than do the poor (who usually have no investments at all) and the middle-class. Indeed, for many rich people in America, dividends on their investments are their primary source of income. Under the federal tax code, income from investment dividends is taxed at a significantly lower rate than regular income. The tax rate on dividend income is currently 15%, whereas the tax rate for regular income is usually between 25% and 35%, depending on the level of income.

If you look at the federal income tax alone, it has the appearance of being progressive, in that people who earn more pay a higher percentage of their income as taxes. But if you look at regular income and dividend income together, the picture quickly changes. The more a person earns from dividend income, the lower their overall tax rate. As a result, the average Wall Street executive pays a lower tax rate on his total income than does the average public school janitor.

As an example, take the world's richest man, Warren Buffet. Curious about the tax burden of the rich vis-a-vis the middle class, he asked the few dozen people in his office to calculate the percentage of their total tax bracket so that he could compare it with his own. It turned out that Buffet paid only 17.7% of his total income in taxes, while his employees paid 32.9% on average.

The rationale for a lower tax rate on dividends is that it encourages investment, which is good for the American economy. On some abstract level, this might make a certain amount of sense. But when the vast majority of the nation's wealth is in the hands of the super-rich, what difference can it possibly make to the ordinary citizens who actually do the work that makes the country function? The fact that the hard-working teachers, police officers, janitors, and other ordinary citizens (the people who actually do the work, in other words) pay a higher percentage of their income than do the super-rich is an utter outrage that shouldn't be tolerated.

Despite efforts by the Republicans to make permanent the Bush-era tax cuts for the wealthy, the 15% tax rate on investment dividends is scheduled to expire at the end of this year. Starting in 2011, dividend income will be taxed at the same level as regular income. This is a development that all 21st Century Jeffersonians should applaud. But it is likely that this process will be challenged in Congress, so we must remain on our guard.

If Jefferson could see the modern American tax system, he would probably call for its complete scrapping and replacement with something completely different. He saw taxation as a necessary evil, and would have recognized the byzantine complexities of the current tax code as a Hamiltonian plot to rob ordinary Americans of their hard-earned money while giving the rich and the powerful enough loopholes (Cayman Islands, anyone?) to avoid paying anywhere near their fair share. The fact that most of the revenue raised by current federal taxation is used to fund dubious and probably unnecessary government programs would have upset Jefferson all the more.

But Jefferson would have seen the blatant inequality in the current tax system as an even greater problem. Believing as he did that "all men are created equal", the unfair advantages given to the rich and powerful by the current American tax system would have shocked and angered him, and he would have rightly considered them a gross violation of the principles of the American Revolution.

In the long-term, we need to shrink the size of the federal government significantly, so as to get the absurd federal budget deficit under control and eventually bring the tax burden down. But the first step in reforming our tax system must be to level the playing field and make sure that all citizens pay an equal share and that no one gets special treatment. And a first step to achieve this is to tax dividend income at the same rate as regular income.