Dividends are taxed first as corporate income then as personal income of shareholders. In contrast, interest paid by the firm is counted as a cost and subtracted when calculating (and taxing) corporate income. Economists have long argued that this creates inefficiencies. I what I vaguely recall as an actual effect of economic theory on policy, if I understand correctly, Glenn Hubbard convinced George Bush to propose the eventually enacted dividend tax cut of 2003 (see line 9b of your friendly 1040 income which isn't included in the sum of taxable income).
I am trying to remember the logic of the tax cut. Now of course the tax cut was encouraged by the general view that capital income of all sorts not be taxed. If income is equally distributed already or if one doesn't care about income distribution, this view makes sense. Also even if one cares about income distribution and capital income mostly goes to the rich the optimal tax on capital income goes to zero as time goes to infinity. I wrote a little model in which the tax should be zero after all inequality has been eliminated and as high as can be collected until then (warning PDF which was very kindly and heroically constructed by Sigve Indregard whom I have never met — isn’t the internet wonderful). There is certainly no case for cutting taxes on capital income now leading to accumulated debt causing higher taxes on capital income in the future - the result is that the tax rate should decline over time.
However, there is also the issue of debt vs equity. Here the tax affects decisions to issue and retire shares. At least in the standard model used by macroeconomists a fixed number of firms exist and they maximize the present value of dividends net of taxes. A constant flat tax on dividends doesn't distort their decisions -- it is a tax they have to pay sooner or later. In this model, imagine imposing a 50% dividend tax on firm A but not firm B. The shares of firm A would lose half their value. Nothing else would change. The tax would have no effect on investment or employment.
Obviously the silly simple model leaves almost everything out.
How about initial public offerings ? There aren't any in the standard simple macro model. They are important. The amount raised with an IPO is greater if dividends aren't taxed. This means more low cost internal financing for new firms with good prospects. This means greater financial rewards for entrepreneurs. Now if we cares only about IPOs the tax cut is poorly targetted -- it would better to subsidize IPOs directly. However, one might hope that the 2003 reform caused an increased rate of IPOs. I don't know what happened to the rate of IPOs from 2003 to 2004. I use the Google and find (pdf) "Where Have all the IPOs Gone ?" by Gao Ritter and Zhu. Oooops doesn't seem to have worked.
Going the other way, favoring debt over equity encourages debt financed mergers and leveraged buyouts. This is a distortion. The causal channel is simple -- the tax cut should have caused higher share prices which makes debt financed takeovers more costly. So what happened ? I ask the google again which sends to to the Wikipedia which has an article on LBOs with the section "The third private equity boom and the Golden Age of Private Equity (2003–2007)" oops.
I stress I am not assuming LBOs are bad or that IPOs are good. The assumption is that if something is done to reduce tax liabilities, the tax is causing dead weight losses.
Double taxation of dividends favors debt. This can lead to financial fragility -- one possible benefit of the 2003 tax cut would be reduced bankruptcies -- ooops.
I honestly didn't know what Google just told me. It sure looks as if the aggregate trends are the opposite of those expected by advocates of the 2003 tax cuts.
I am sure no one is convinced by looking at the time series of IPOs LBOs and bankruptcies. There aren't enough data to prove anything. A whole lot of things are going on. However, I don't see a practical alternative. The issues are the creation and destruction of publicly listed corportations. They can't be addressed by looking at a panel of firms.
In any case, I found no evidence at all that the tax cut had the expected effects.