A Cut in the Capital Gains Tax Rate - We Just Got One
IN THIS ISSUE:
1. The Stealth Tax Cut The Media Missed.
2. “Excludable Distribution Accounts” (EDAs).
3. More Analysis Of The Bush Tax Plan.
4. Who Are “The Rich?” You Might Be Surprised!
An Overlooked Benefit In Bush’s New Tax Plan
As expected, the Democrats and the media have gone ballistic over Bush’s latest tax plan. By now you’ve heard all the sound-bites: “tax cuts for the rich,” “favors the richest 1%,” “shot in the foot, not the arm,” “soaring deficits,” etc., etc. In particular, the Democrats have the most heartburn with Bush’s plan to eliminate the tax on dividends.
Yet there is one provision in the Bush tax plan that the Democrats and the media have largely missed. It’s called the “Excludable Distribution Account” (EDA), and it will amount to a cut in the capital gains tax rate. Let me explain.
When Bush and his tax planners decided to go for eliminating the tax on dividends, they realized that, if successful, this could lead to a boon for companies that pay dividends, while it would be a disadvantage to the many companies who don’t. Small, fast-growing companies, which make up the bulk of the economy, don’t typically pay dividends; they plow after-tax profits into reinvestment to grow the business.
The Bush administration decided to level the playing field for small, growing businesses. Here’s how it works. Under Bush’s new plan, after companies pay their taxes, they can put what remains of their profits (retained earnings) into an EDA. If the company doesn’t pay that money out in dividends, but keeps the profits for its own use, the shareholders get a tax break.
A Specific Example To Illustrate How EDAs Work
Let’s say you bought ABC Corp. at $10 a share. Over the next year, ABC does well, sets up an EDA and puts the equivalent of $2 a share in it. Because ABC has done so well, the stock price has risen to $20 a share. If you decided to sell ABC at $20 a share, you would have to pay a 20% capital gains tax on the $10 gain, or $2 per share in taxes.
But under the Bush plan, you would be allowed to subtract the EDA value of $2 per share from your $10 gain for tax purposes. In other words, you would only pay taxes on $8 per share, not $10. In this example, the capital gains tax would only be $1.60 per share ($10 - $2 = $8 X .20 = $1.60). That’s a 20% cut in the capital gains tax rate. If ABC had done even better, say $3 per share in profits in the EDA, that would be a 30% reduction in the tax rate.
Or, let’s say you buy XYZ Corp. at $100 a share, and it puts $6.50 in an EDA in the first year. In the same year, its stock rose to $110. In this case, if you were to sell it, you would only pay taxes on a gain of $3.50 per share.
According to the Wall Street Journal’s (Jan 9) analysis of EDAs, even if you don’t sell your shares at the end of the year, you get to increase your cost-basis by the amount of the EDA. In the case of ABC above, your cost basis would increase from $10 to $12, and it would continue to rise in future years, assuming ABC continues to increase its EDA.
This is good news, both for companies that don’t pay dividends and for investors. These companies are encouraged to make profits and retain earnings, which is good for the economy. And because they are not at a disadvantage to companies that do pay dividends, they will be attractive to more investors. Caveat: once again, we don’t have many details on the EDA, so as more info becomes available, we may find it is not as significant as it seems initially.
Are The Bush Tax Cuts Fair?
After my brief analysis of the Bush tax plan in last week’s Forecasts & Trends E-Letter, I received many comments from readers, both for and against the plan. I also received a few e-mails from readers who scolded me for using the administration’s “average” benefit numbers. They pointed out the obvious, that such estimates could be skewed toward the richest Americans, and still show to be reasonable in the average.
You will recall that I noted last week that the White House had not revealed how the tax cut estimates were calculated, and that they were the only numbers we had to work with at the time. Now that we know more details of the plan, it is easier to see exactly how the tax cut provisions will affect “regular” families.
The bottom line is that the Bush tax plan benefits those who actually pay income taxes, and families with children at lower income levels.
The Tax Foundation, a Washington, D.C.-based non-profit group, recently prepared an analysis of how the Bush tax cuts would affect families with children at different income tax levels. The results are very revealing and can be found at the link following this article. Here are three examples.
They found that the median family with two children earning $67,000 per year would receive a tax cut of $1,133 this year, eliminating 22% of their current tax liability. A family with two children earning $40,000 per year would get the same amount and see 96% of their tax liability erased. A family with two children earning over $200,000 would see only 9% of their income tax liability erased.
One of the most interesting notes that I found in the survey said that families earning below $35,000 per year were not included in the analysis because the tax cuts enacted in 2001 had already effectively eliminated all of their income tax burden.
More Class Welfare… I Mean Warfare
Of course, the Democrats have had a field day with Bush’s tax plan because they do not concentrate on the percentage of tax relief, but rather the dollar amount. In the examples above, the family earning $40,000 and our median family earning $67,000 per year both get a total tax break of $1,133, while the family earning $200,000 receives a tax break of $3,077, or almost three times as much.
So, while the percentage relief is skewed in favor of the little guy, the total dollars still favor the upper income taxpayers.
Never mind, of course, that the family earning $200,000 – three times as much as the family earning $67,000 – will have to pay over 8 times as much in income tax than the family earning $67, 000, this according to The Tax Foundation’s latest analysis.
The Democrats’ plan, on the other hand, puts a $300 check in the hands of everyone ($600 per couple), whether they paid taxes or not. I’m sorry, but this seems more like welfare than sound tax policy.
Of course, the Democrats believe that putting cash in the hands of families who really need it will result in consumption, since they are more likely to spend the money than save it for a rainy day or invest it. On this, I’ll have to side with the Democrats. Lower-income families, especially those with a couple of school-aged children, will have plenty of places for $600 to go.
However, this same family would do better under the Bush plan even if they earn an income that would have previously exempted them from taxes. That’s because they get the extra $400 per child in tax credits. Two kids equal $800 in additional tax credits, and this is better than $600.
Two-parent families with one child would not fare as well under the Bush plan as with the Democrats’ plan, since they would only get one $400 child tax credit. However, the ever-growing single-parent households would fare better even with one child, since the $400 credit would be more than the Democrats’ $300 check to a single taxpayer.
A Question Of Perception
Obviously, whether one supports the Bush tax plan, or not, depends upon their perception of what it does for them. However, the liberal media is pulling out all of the stops in an effort to paint the Bush tax plan as nothing more than a boost for the rich. One good example was a recent New York Times article that distorted the impact of the tax plan on a family cited as an example. As a result (and somewhat predictably), the head of the family in the NY Times article said he was “not impressed by the President’s tax plan,” a perception primarily based on the fact that the family had no significant stocks, so the dividend exclusion would not benefit them.
However, the Washington Times ran a subsequent editorial criticizing the Times for not informing the family that the other provisions of the Bush tax plan would have shaved 30% off of their 2003 tax bill. Well, the New York Times surely can’t let a few facts get in the way of a really good quote now, can they? (You can get all of the details of the original New York Times editorial and the real effects on this family in the Washington Times in the links I’ve provided below.)
This is just one example of how the liberal media is seeking to force a perception upon the American people. I don’t mind if people disagree with my position, as long as their disagreement is based upon facts. I am an independent and call things the way I see them, so I get e-mails from liberals about being too conservative, and sometimes even from conservatives who think I’m not nearly conservative enough.
However, it really burns me up when I see the talking heads on TV intentionally slanting the news and/or leaving out key facts and/or flat out lying in order to create a perception!
The Bottom Line On Any Tax Reduction Plan
Let’s cut to the chase. Whether you are a conservative or a liberal, there are a few basic points that really aren’t debatable; they’re just facts.
Note that I did NOT say it is “impossible” to have a tax reduction plan that favors the lower income people. There are some liberals who believe that the top 50% should pay all income taxes, not just 96%. There are others that believe the top 40% should have to pay all the income taxes, with the bottom 60% paying nothing.
Sorry folks, but to me it looks like those on the lower end of the income scale have already received plenty of relief. It’s time to start providing a few benefits to those who are carrying the load.
[And to pre-answer some of your e-mails, I know I’m just talking about income taxes and not Social Security Tax. However the Social Security Tax, as well as the entire Social Security System, is a whole different story, one that I’ll be glad to tackle in a future issue of the Forecasts & Trends E-Letter.]
Two Irreconcilable Positions
In essence, it comes down to the economics of politics. The conservatives believe in providing tax breaks to those who actually pay taxes. They believe those with higher incomes will invest money from tax breaks in established business, or start new small businesses. In turn, this investment will go to purchase plants, equipment and inventory that will, in turn, create jobs and opportunities for everyone. This willingness to invest “risk capital” is the basis upon which capitalism is built, and like it or not, it is what has made this country great. Unfortunately, this process is a slow one, since it takes a while for investments to be made and work their way through the system.
The liberals, on the other hand, do not believe in this model. Instead, they believe in the Keynesian view of the government providing the necessary stimulus through spending programs. In the current case, they believe the $300 per taxpayer checks will be spent, thus increasing consumption to kick-start the economy in the short-run. This is possible, but the Bush tax rebates in 2001 ($300-$600) didn’t exactly send the economy soaring.
As a general rule, you are not likely to reconcile these two polar economic opinions. You may find someone converted from one to the other on occasion, but these two theories tend to mix like oil and water. So, you’re not likely to see anyone put them together and explain the US or global economy.
It All Goes Back To Politics
We must all realize that both plans were developed under the supervision of politicians, with their own respective re-election plans in mind. The Democrat plan has some legitimate provisions that would be good for the economy and small business in the short-run, but it fails in terms of true tax reform.
The Bush plan, on the other hand, has some very good provisions that would be good for business and the economy in the long-run, but is also geared toward supporting the stock market, which has now been politicized (much to my chagrin).
While I have spent a lot of time explaining my previous explanation of the Bush Tax Plan, now that we have more of the details, let me remind you that I am not at all certain that we need ANY stimulus plan for the economy to keep growing. As much as the Dems would have us believe otherwise, 3% growth in 2002 is not too shabby.
As I stated last week, if I had to pick one of the two, I’d pick the Bush plan, but by the end of the year, we may find that we needed neither, at least in terms of the economy.
I do think the elimination of the tax on dividends is a good idea and one that is long overdue. The liberals would have us believe that only the “super-rich” receive dividend income, but this is NOT true. As you can read in the link below from The Tax Foundation, 45.8% of all tax returns claiming dividend income in 2000 came from those making $50,000 a year or less. The liberals never quote this figure. Imagine that! In fairness, however, it is true that the wealthy pay a much larger percentage of total dividend taxes than those earning $50,000 or below.
And Finally, Who Are “The Rich” Anyway?
If you make $28,000 a year, do you consider yourself rich? What if you make $55,000 a year, are you rich? Okay then, what if you make $92,000 a year, are you rich? I doubt that many in any of these income brackets consider themselves rich, especially if they have kids.
However, if you make $28,000 a year, you are in the top 50% of taxpayers; $55,000 puts you in the top 25%; and $92,000 puts you in the top 10%, the so-called “super-rich.”
The liberals NEVER quote these figures either. They know that most people making $28,000-$55,000 do NOT consider themselves remotely to be rich, nor do many who make $92,000. These folks would be appalled if the liberals were to call them rich people, so they don’t.
Parting Thoughts – Agree Or Disagree
This E-Letter now goes out to apprx. 1.6 million people on a weekly basis, and that number is expected to top 2 million before long. No matter what I say on any subject, there will be those who agree and, of course, those who disagree. But as noted above, I call it like I see it (not that I am always correct). Long-time readers know that I am just as quick to criticize Republicans when I think they are wrong as I am the Democrats.
There are those who respond by saying I should not be commenting on political issues at all, given that my primary business is that of an Investment Advisor (Hint: these almost always come from people who disagree with me.). For the record, I very much believe that politics influences the investment markets, sometimes in profound ways, especially tax policy.
My political commentaries consistently rank among my most popular topics, especially with long-time clients and readers (based on surveys we do), even if they disagree with me politically. So, I will continue to discuss politics from time to time as I see fit.
We get hundreds of e-mails from readers every week. I appreciate them all (with a few nasty exceptions now and then) whether you agree or disagree. While we try to respond to them all, it is impossible to provide detailed responses, due to the shear numbers, and especially those that want long, complicated answers. So, please keep them short. Regardless, I appreciate your comments and suggestions.
Gary D. Halbert
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.