Taxes, one of the few certainties in life, have been the source of a lot of uncertainty this election year.
A major drawback of the U.S. tax code is that so many of its provisions expire. As a result, it requires additional congressional action to extend them. There are several reasons for this legislative framework, with some, at least theoretically, designed for the public good. For starters, it compels Congress to re-examine past decisions. It also helps ensure that both the tax code and the government’s revenue needs are evaluated against a backdrop of current budgetary realities.
Yet, at the same time, sunset provisions are often rooted in cynicism, as they force impacted interest groups to return to Capitol Hill to ask for favors. They also allow lawmakers to pass short-term tax cuts, and thereby avoid derailing long-term deficit projections, which tends to alienate voters. People hate deficits, but they also dislike the mundane prescription of spending cuts or revenue increases to reduce them.
The fate of these so-called “extenders” is often debated against a ticking clock, which usually forces Congress and the President to reach a last-minute deal. More often than not, the outcome fails to meet expectations on both sides of the aisle.
Among the issues that have recently captured the most attention is a provision of President Obama’s proposed budget to Capitol Hill. The proposal, released in February, would raise the tax rate on corporate dividends for individuals earning more than $250,000 to 39.6% from 15%. The President’s plan is predicated on the belief that dividend income should be taxed at the same rate as ordinary income. It assumes that the 2001 Bush tax cuts that reduced the income tax rate to 35% from 39.6% for the highest earners would expire. Boosting the tax even higher is an additional 3.8% investment tax surcharge that is imposed under the Obama health care law.
The President’s proposal caught most observers by surprise. And it wasn’t because it sought to raise taxes on dividends; it was the size of the suggested increase that was so startling. Most of us in Washington knew that the major plank for his re-election was going to be “economic populism,” a core message he underscored in his State of the Union address. That was evident when he sat Warren Buffet’s secretary, Debbie Bosanek, next to the first lady. Her presence as a stage prop was intended to evoke Buffet’s longstanding argument that the U.S. tax code is unfair; his personal secretary’s income is reportedly being taxed at a 35.8% rate while his income is taxed at a more modest 17% rate. Still, the prevailing sentiment was that President Obama’s tax hike would raise the dividend tax to 25%, and not the 39.6% submitted to Congress.
The current 15% dividend tax rate was enacted during the Bush administration in 2003, when the Republicans controlled both houses of Congress and the White House. It was coupled with a parallel reduction in capital gains taxes. Those tax provisions were scheduled to expire at the end of 2008, but Congress intervened in 2006 to extend the reduction through 2010. Congress took action again in late 2010 to allow the lowered rates to remain in effect until the end of 2012.
The President’s proposal goes beyond the academic belief that income earned—whether from labor or investments—should be treated the same under the tax code. Perhaps more important in this era of unprecedented deficits is an assumption that if taxes were raised, then the government would bring in more revenue. The Obama administration projects that it would raise over $200 billion over the next 10 years.
Opponents of the tax hike, which include the U.S. Chamber of Commerce, the Business Roundtable and almost every other business group in Washington D.C., argue that the President’s proposal, if enacted, would be particularly damaging for older Americans. The IRS estimates that people over age 55 receive more than 75% of all dividends. Business groups are trying to make the case that not only would the President’s proposal hurt senior savers, but also it would damage the U.S. economy by making it more difficult for businesses to attract capital.
Critics also dispute the notion that roughly $200 billion in additional revenue would line the federal coffers. They argue that this sum would fall far short of that target because businesses would respond to the higher tax rates by reducing their dividends. The net impact, according to some economists, would be that companies would sit on their cash. Hording cash instead of paying it out as a dividend or reinvesting it would likely have a debilitating effect on stock prices and the economy at large.
Historically, the dividend tax has always been a divisive issue. Supporters of higher dividend taxes believe that lower tax rates disproportionately benefit the wealthy. They argue that wealthy people should pay the same taxes on their earnings as a school teacher, farmer, or anyone else who makes their money through traditional employment. Meanwhile, opponents claim that the tax is already unfair, in that the companies that pay dividends are sometimes paying more than 35% in federal taxes on their earnings before distributing them to shareholders. As a result, people who own shares in stocks are being asked to pay twice—once when the company makes money, and again when it passes the earnings along to shareholders. Further adding to the tax burden are income taxes imposed on various states, some of which exceed 10% for upper-income individuals.
With 2012 already being consumed by politics, it is widely expected that nothing will get done until after the November elections. The President is running as “the champion of the middle class” and hopes the Buffet rule will help him score some political points.
However, if his 2013 budget proposal is enacted, then it may spark a controversy that would send Americans who think they will be paying higher taxes into an uproar. According to the Investment Company Institute—the U.S. mutual fund industry’s largest trade association—an estimated 51% of all U.S. households own stock directly or through mutual funds. Rest assured that opponents of the bill will be engaged in an extensive grassroots campaign to educate the public about the looming higher taxes. Further, they will enlist the full heft of their lobbying support to tell Congress that a dividend tax increase is unacceptable.
Making predictions comes with the territory in Washington and those who make them—including me—often hope that no one really remembers what you said when they don’t come true. That said, my personal view is that the President’s proposal was designed to be a political stalking horse. In the end, the administration and Congress might come up with a deal that retains the parity of tax treatments that now exists between long-term capital gains and dividends taxes. But any compromise might also raise dividend taxes closer to the 20% tax rate on capital gains, another key tenet of the President’s budget proposal.
What we know for sure is that the political handwringing will continue and the issue, eventually, will be addressed after the election—likely at the eleventh hour. One can only hope that this hot-button issue won’t be another missed opportunity for lawmakers to collaborate and compromise. At the very least, the American people deserve to see more hand holding and less finger pointing.