Posted 5:10 PM by Robert

Unintended Consequences

Any proposal as dramatic as the elimination of federal taxes on dividends is bound to have some unintended consequences. The New York Times reports on an interesting one: the cost to state tax receipts.

The states fear they will lose in two ways. Because state income tax laws are tied to the federal law, the states will also stop taxing dividends. In addition, the removal of taxes on dividends makes stocks a more attractive investment vehicle than the traditionally tax-free municipal bonds.

The Times presents these "unintended consequences" (surely no serious person thinks these consequences are "unintended" - or at least "unanticipated") as a disaster, but on closer inspection the consequences all seem rather positive.

The first concern is just silly - if a state wants to tax dividends received by its people, it can do that. It might take a revision of a state's tax code, but that's something for the state legislature to take care of. States tax all kinds of things that the federal government doesn't tax - real estate, retail sales and lots more. One nice side effect of this particular "unintended consequence" is that state legislatures will have to take affirmative action to maintain their tax on dividends and explain why they are taxing dividends while the federal government doesn't - which should be painful for the legislators. That's good - although the Times thinks it's bad.

The effect on municipal bonds is more interesting. The President's plan provides for additional federal aid to the states. Many people are taking that as intended to shore up state finances in the wake of the stock market decline - and the consequent decline in state income tax revenue. To the extent the new aid is intended to compensate the states for that shortfall, it is very bad policy - as others have pointed out. Many states, especially California, have run their spending up wildly "assuming" that capital gains tax revenue from securities sales would continue indefinitely. There is no good economic reason to help the states out of that absurd problem.

But to the extent the new state aid can be considered to replace the implied subsidy the states have received for decades from the tax-free status of municipal bonds, it is justifiable at least as much as the original subsidy was justifiable. To that extent the new state aid would not represent a deterioration of federal tax policy.

There may be another component to these unintended consequences which is not discussed by the Times article: If the state concerns are right, then the value of already-outstanding municipal bonds will decline - and the current holders of those bonds will take a loss. Municipal bonds are traditional "widows and orphans" investments - so those losses might be concentrated in a particularly sensitive portion of the electorate.

The municipal bond tax exclusion itself is highly questionable. There is no good reason why the kinds of projects favored by municipalities should be subsidized in the capital markets. The subsidy encourages inefficient, excessive investment in certain kinds of capital-intensive projects. Further, the exclusion is a disguised obstacle to privatization of many public services because a municipality can more easily fund certain facilities than can private (taxable) enterprise. For example, many municipal sports stadiums are owned by municipalities and financed by tax-free municipal bonds - all to the service of privately owned sports leagues. There is no good reason for this.

But why should investors pay taxes on interest payments received on private bonds but not on interest payments of municipal bonds or dividend payments by private companies? Does the Bush plan move us from a system which irrationally favors corporate debt over equity to one that irrationally favors equity over corporate debt? That effect may be small, since interest payments are already deductable by the companies from the corporate income tax.

But that's not a proof.

MORE: An interesting e-mail exchange with Jane Galt turned up the following interesting nugget from Constitutional history:

A far-reaching extension of private immunity was granted in Pollock v. Farmers' Loan & Trust Co., 157 U.S. 429 (1895), where interest received by a private investor on state or municipal bonds was held to be exempt from federal taxation. (Though relegated to virtual desuetude, Pollock was not expressly overruled until South Carolina v. Baker, 485 U.S. 505 (1988)).

In short:

For almost 100 years the Court held that the federal government could not tax municipal bond income - and then reversed itself in 1988.

STILL MORE from Fritz Shranck. He says the law of unintended consequences will likely kick in when the states move to compensate for the changes in the federal tax code.

My use of the term "unintended consequences" above to describe the effect on municipal finances is, of course, ironic.

Fritz is surely correct that strange things - and true "unintended consequences" - can be expected once the state legislative logrolling begins in earnest.

God, the scene under the dome in Sacramento will resemble some outtake from Beetlejuice with Gray Davis in the title role.

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FURTHER UPDATE