Dividends aren't only income taxed twice

Yes, something is more painful than paying a tax.

Paying a tax twice.

President Bush reminded us of this most recently. He wants to eliminate the tax on corporate dividends as part of his stimulus program. Because corporations pay corporate income taxes on all earnings and then distribute some of those earnings as dividends, it is double taxation when individuals pay taxes on dividends.

Well, I have a better idea.

Corporate dividends aren't the only source of income that is taxed twice. Other forms of income that are taxed twice are received by more people and will stimulate the economy more.

The largest and most pervasive tax in America is the employment tax. It's the one used to support Social Security and Medicare. That tax is taken out of our incomes, but it is not deductible when we calculate our federal income-tax bill. As a result, many people pay income taxes on their employment taxes, essentially paying taxes on taxes.

We could correct that and restore a lot of purchasing power to people who aren't rich simply by subtracting employment taxes from taxable income.

But wait, there's another step.

The employment taxes we pay make us eligible for a variety of benefits — health, disability, survivor and retirement. These benefits were tax-free until 1983.

In 1983 our friends in Congress voted to increase the employment tax and increase the retirement age in the future. Basically, those who were still working were told they would pay more in taxes but get fewer benefits because the retirement-age increase effectively cut future benefits. Most people still retire between 62 and 65.

Congress also decided to tax some retirement benefits.

Net-net, they gave great reassurance to the people who were collecting benefits at that time while sticking it to people who would retire at least 20 years later. (As usual, the Nows did well, and the Laters were poorly served.)

Now fast-forward 20 years to 2003. The tax is biting deep.

Here's how it works. If the combination of half of your Social Security income plus your adjusted gross income from other sources plus your tax-free income from municipal bonds exceeds $25,000 for singles or $32,000 for couples, a portion of your benefits will be taxed.

In 1993 the limit was raised from 50 percent of Social Security benefits to 85 percent, creating some of the highest marginal tax rates in America.

Indeed, the only thing that wasn't raised was the threshold for paying the tax. Those $25,000 and $32,000 tax points have been the same since 1983, unindexed to inflation.

Like submerged rocks in a river of ever-decreasing purchasing power, they hit more retirees each year as inflation raises incomes without increasing purchasing power.

As a consequence, many retirees are now paying income taxes on the benefits that come from their employment taxes. It could be argued that they are paying taxes three times on the same income. (In fairness, it also could be argued that their original tax payments are quickly recouped and the rest is new income that has never been taxed.)

However you argue it, it's a cruel tax. Middle-income retirees who saved for retirement pay marginal income-tax rates as high as 50 percent. It also means that millions of people who plowed money into tax-deferred accounts to save 27 percent in taxes will take out dollars taxed at 50 percent.

What does this mean in practical terms?

Simply this. Millions of retirees must withdraw $2 from their IRAs to have $1 to spend at Burger King. The other dollar goes straight to the Internal Revenue Service. Cut the tax and you'll stimulate the economy.

Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at scott@scottburns.com. Questions of general interest will be answered in future columns.