BUSH’S TAX CUT - WHAT IT MEANS FOR YOU

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
May 27, 2003

BUSH’S TAX CUT - WHAT IT MEANS FOR YOU

Introduction

President Bush was successful, sort of, in getting a new tax reduction plan through Congress late last week. I say sort of because Bush originally wanted $750 billion in tax relief but in the end got only $350 billion, including a reduction in the capital gains and dividends tax rates. Also, most of the new tax cuts contain “sunset provisions,” meaning that they go away after 2004 in most cases, unless extended.

Those who favor the tax cuts say they will stimulate the economy back to 3-4% economic growth and boost the stock markets. Those who oppose the tax cuts offer the same old arguments that they benefit only the richest Americans and will balloon the deficits. As usual, the truth is somewhere in between.

If jump-starting the economy was the main goal of the tax cut, I don’t believe it is nearly big enough to accomplish that feat. Fortunately, the economy is already improving on its own. If stimulating the stock markets was the main goal of the tax cut, they should have simply eliminated the dividends tax, rather than creating the new, complicated formula.

In the past, I’ve written, “I never met a tax cut I didn’t like.” I stand by that but the latest tax package is very disappointing.

The Research Institute of America (RIA) ( www.riahome.com) has just released the following summary of the new tax resolution. Hopefully, this rather brief summary will help you to understand what the new tax changes mean for you.

RIA Summary Of New Tax Resolution.

QUOTE:

Your income will be taxed at lower rates. For regular tax purposes, the first "slice" of your taxable income is taxed at 10%, and additional slices of taxable income are taxed at progressively higher rates until you reach the maximum rate. The various "slices" of taxable income, and the tax rates each is subject to, are commonly referred to as the "tax brackets." All of the following tax rate cuts apply retroactively to Jan. 1, 2003:

... If you file as a single person or are a married person filing separately from your spouse, the first $7,000 (instead of $6,000) of your taxable income will be taxed at 10%, the lowest tax rate. Because the extra $1,000 was taxed at 15% under prior law, you save a maximum of $50.

... If you file a joint return, the first $14,000 (instead of $12,000) of your taxable income will be taxed at 10%, the lowest tax rate. Because the extra $2,000 was taxed at 15% under prior law, you save a maximum of $100.

... If you file a joint return, more of your taxable income will be taxed at 15% (instead of winding up in the next highest tax bracket and being taxed at 25%).

... The new law reduces all of the tax rates above 15% for all individuals (as well as estates and trusts). The new tax rates above 15% are: 25% (instead of 27%), 28% (instead of 30%), 33% (instead of 35%) and 35%, the top rate (instead of 38.6%).

How much will all of these tax rate changes save you? The answer depends on how much taxable income you have and your filing status. For example:

... If you are single with $60,000 of taxable income for 2003, your tax bill will be $682 less. If your taxable income is $120,000, you save $1,882.

... If you are married, file a joint return and have $60,000 of taxable income for 2003, your tax bill will be $1,286 less. If your taxable income is $120,000, you will save $2,486.

The tax savings will be higher if taxable income included dividends or capital gains (taxed at a lower rate under the new law, see below). Additional tax savings will be realized if the individual is entitled to an enhanced child tax credit.

Wage-earners will get a larger paycheck as a result of these (and other) changes for individuals. The IRS says payroll withholding will reflect the new law as soon as employers and payroll processors put new withholding tables into effect.

Bigger standard deduction for joint filers. If you are married, file a joint return, and don't itemize your deductions, your basic standard deduction for 2003 is $9,500, a $1,550 increase. There's no increase in the additional standard deduction amounts for elderly and blind persons.

Bigger alternative minimum tax (AMT) exemptions. The alternative minimum tax, which is payable only if it exceeds your regular tax bill, is a hazard because many tax breaks ("preferences") allowed for purposes of calculating regular taxes are disallowed for AMT purposes. The "preferences" are added back to regular taxable income, an AMT exemption amount (which phases out at higher income levels) is subtracted, and the balance is subject to an AMT rate of 26% or 28%. The new law makes the AMT less of a problem by increasing the maximum AMT exemption amount to $58,000 for marrieds filing jointly (a $9,000 increase), to $40,250 for unmarried individuals (a $4,500 increase), and to $29,000 for married individuals filing separate returns (a $4,500 increase).

Boosted child tax credit, partially refundable for 2003. The child tax credit for 2003 is $1,000 per qualifying child (a $400 increase over the prior-law $600 amount). What's more, the increased amount of the child tax credit will be paid "in advance" beginning in mid-July over a period of three weeks. This year, a qualifying family with one child will receive an advance payment check from the Treasury for up to $400, and a qualifying family with two children will receive a check for up to $800. The amount of advance payments will be based on a person's 2002 filing status and income, as well as the number of children claimed on the 2002 tax return who will still be under age 17 in 2003. Note that the new law didn't change the income levels at which the child credit starts to phase out ($75,000 for singles, $110,000 for married couples, and $55,000 for marrieds filing separately).

Reduced taxes on capital gains and dividends. For sales and exchanges (and installment payments received) after May 5, 2003, gains on most capital assets held longer than one year will be taxed a maximum rate of 15% (instead of 20%). The maximum tax rate on capital gains drops to 5% (instead of 10%), if it would otherwise be taxed at 10% or 15% (that is, if it were ordinary income such as salary). In addition, dividends you receive in 2003 from a domestic corporation (or certain "qualified foreign corporations") are taxed at the same rates that apply to capital gains. In other words, the dividends are taxed at rates of 15% or 5%. These new capital gain and dividend rates apply for both the regular tax and the AMT.

What the future holds in store. Unfortunately, to meet budget constraints many of the tax breaks in the new law are not permanent. For example, unless Congress changes the rules again, the new tax breaks for marrieds filing jointly (more income taxed in the 15% tax bracket instead of a higher tax bracket, and larger basic standard deduction) are slated to be watered down after 2004, the AMT exemption amounts will drop after 2004, and the maximum child tax credit also will drop after 2004. What's more, the reduced tax rates for capital gains and dividends will only last through the end of 2008. This will make it much harder for all of us to plan for the long haul.

END QUOTE

Investing Long-Term When Taxes Change Short-Term

We are all told to invest for the long-term. We are also told that tax cuts should stimulate us to do just that. However, due to the sunset provisions in the new tax deal, investors don’t know if many of the new tax cuts and rate reductions will remain after 2004. Also, it is always possible that the Democrats could regain control of Congress and repeal these latest tax cuts, or even Bush’s first tax cuts in 2001.

In my January 7, 2003 ( Link) Forecasts & Trends E-Letter, I compared Bush’s proposed tax bill to the one proposed by the Democrats. In that comparison, I favored the Bush proposal because I believe in supply-side economics. That’s where money from tax cuts is invested in new businesses and expansion of existing businesses. This creates jobs, and thus increases consumer spending eventually.

The problem with the supply-side story is that this process takes a while. Many economists have already gone on record to say that the current tax cut will do little to help the economy by the elections in 2004. I tend to agree, but I continue to believe the economy is recovering – with or without the tax cut.

What bothers me most about the new tax plan, as noted above, are the sunset provisions. How much of the tax cut will be invested in long-term business opportunities if those who invest do not know what the tax implications of their investment will be when they cash out or start to receive dividends? As a financial advisor, I would have a hard time advising a client to make a long-term investment that is primarily based on stable tax policy.

Of course, the Republicans believe that making the tax cuts permanent is just a matter of time. I don’t know that I share their enthusiasm. Just look at the attempts to make the elimination of the estate tax permanent. The permanent repeal of the estate tax has not passed yet, and may never do so.

And What If The Democrats Regain Control?

If the Democrats do take control in the future and propose to allow the tax cuts to lapse, the Republicans will be able to make political hay by claiming the Democrats are raising taxes by not extending the tax cuts. This will be politically damaging even though the Dems will likely counter that they are just correcting an inequity that allowed the “rich” to get the most benefit from the tax cuts. (See my January 14, 2003 ( Link) E-Letter to learn just who the “rich” really are.)

However, if the Dems take control, they may be successful in raising taxes, possibly even above and beyond allowing the tax cuts to lapse, IF they can convince the American public that a sufficient crisis exists. What might this be? I think it could take the form of a Social Security, Medicare and Medicaid crisis.

We are now within a decade of the retirement of the older Baby Boomers. This first wave should not, by itself, bring about a funding crisis. However, I think it will thrust the anticipated Social Security/Medicare/Medicaid shortfall into the limelight, and will be a much more urgent issue than it is right now.

I don’t have the room to go into all of the ramifications of the Baby Boomer retirement wave, so I’ll save that for a future E-Letter.

Conclusions

I don’t want to leave the impression that I am against the latest tax cut. I’m not. My point is that if the Republicans wanted to jump-start this economy to a more rapid recovery, this is not the bill to do it. I personally think that this tax bill is too little, too late if that was their goal. Fortunately, the economy would have continued to improve with or without it.

The other problem I have is that the latest plan is only a temporary tax cut. Much of it can disappear after next year, due to the sunset provisions, especially if the Democrats were to regain control of Congress. While it appears today that Democrats will actually lose seats in 2004, we all know that could change.

At the end of the day, this latest tax cut was very likely driven more by political motives than economic. The highly contentious tax cut allows Bush to be seen as not ignoring the economy as his father did after the first war with Iraq.

Bottom line: Is the tax cut a good thing? Yes. Will it accomplish the stated goals and desires of the Bush administration? Not likely.

Best Wishes,

Gary D. Halbert

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