Should the U.S. Follow China’s Dividend Tax Relief?

We have to give at least a little credit to Chinese regulators. While they let their market skid out of control in the past year, equally unable to stop the bleeding during July and August of this year, China’s newly proposed dividend tax rules are a simple, clean and bold change. And they just might quell some of the volatility plaguing China’s market.

U.S. Regulators Should Study China's Dividend Tax Relief CarefullyGranted, the measures aimed at discouraging short-term trading by lowering taxes on dividends of long-held positions won’t solve all of the nation’s equity market woes.

Yet, it’s intriguing, and begs the question for U.S. investors: Could our regulators ever put a similar tax plan in place (even if just temporarily) to calm our markets?

China’s Short-Term Dividend Tax Rules

Much like the way our IRS treats capital gains differently depending on the length of time the position is held, China’s government has instituted a new — albeit temporary — tiered system of taxes on dividends paid by Chinese stocks based on, you guessed it, the length of time held.

Effective immediately, dividends paid by stocks that were owned for less than a month will incur the normal 20% tax bill, but stocks held between one month and a year will halve the owner’s tax rate. Long-term investors holding stocks for more than a year, however, will find the dividend tax has been eliminated altogether.

Unlike U.S. dividend tax rules, China’s dividend taxes are calculated at the point in time the position is sold, allowing brokerage firms to accurately determine which of the aforementioned scenarios applies.

The aim and likely outcome isn’t a veiled one: Beijing wants to discourage the rampant short-term trading that has provoked China’s stock market since the middle of last year. These measures do just that, and they do so immediately.

But it’s not without its critics.

The biggest of these arguments is the notion that dividends play a small role in the concerns of Chinese investors, as dividends offer only a fraction of the potential gain Chinese stocks offer. In that light, it may have been more effective for Beijing to tweak the country’s flat capital gain tax rate of 20%, pushing the figure higher on short-term trades and lower for longer positions.

Still, China’s revision to its dividend tax rates was perhaps the kind of quick and dirty initiative the country needed to fix its market’s equilibrium.

How Are Dividends Taxed in the United States?

The recently revamped divided taxation rules in China serve to underscore just how different their taxation system is from ours. As a refresher, in the United States:

  • Broadly speaking, dividends paid by U.S. companies are taxed at rates anywhere from 10% to 20% less than an individual ordinary income tax rate, though taxes are due by tax-filing time in the year after they’re paid.
  • Long-term (positions held for more than one year) capital gains in the United States are taxed at a top rate of 20% for most investors, while short-term capital gains are taxed at an individual’s normal income tax rate, which is anywhere from 10% to 39.6% of income.

It’s clearly a more complicated system than China’s, even with China’s recently revised dividend tax schedule. But there is one common element among both schemes: They’re designed to encourage long-term positions and to discourage short-term trading, even if neither the carrot nor stick goes far enough.

Still, could the U.S. borrow this page from China’s playbook if and when the need for volatility containment arose? Would we even want to?

Never Say Never (But Don’t Hold Your Breath)

Philosophically speaking, the premise is rather clever, if a bit limp.

It gives Chinese investors total control over when they incur taxes on dividends (even on existing positions); and as such, does indeed make most investors think twice about selling. That’s in contrast to the U.S. system, which levies a dividend tax liability when payment is made with no regard to the holding period.

On the flip side, the speed and decisiveness with which China put its new dividend tax rules into place is almost a bit scary.

For better or worse, China’s government’s taxation arm — as well as its central leadership and securities regulators — are all ultimately one and the same, and don’t need any particular legal approval to effect such a change.

Welcome to communism.

Never even mind the legal logistics of the idea, that sort of arrangement simply couldn’t exist in the United States; as the odds of the SEC, the IRS and Capitol Hill all getting on the same page that quickly isn’t even a pipe dream.

Welcome to democracy.

And then there’s the simple matter of change … most U.S. investors — institutional and individual alike — tend not to like change simply on principle, and would undoubtedly grouse about such measures using the familiar lack-of-liquidity argument.

Still, U.S. overseers may want to watch and learn from China, and at least mull over similar measures (focusing on capital gains rates rather than dividend taxation) if and when it looks like we’re headed into another financial crisis.

China’s quirky idea just might make a difference.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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