Tax Rates and the Fiscal Cliff (a/k/a the ALLEL-GBTD-HSS-2001)

Thursday, November 8, 2012 at 1pm
By John Friedman

We now return to our normally scheduled program . . .

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The election of 2012 is over and at least day-and-a-half-after debriefed.

My how things have changed. Looking back we see how:

     Twelve years ago we, as a nation, made decisions which, when aggregated, were tantamount to a coin flip in which the coin ended up on its edge for 35 days and then, via 537 votes in FL and 1 vote on the SCOTUS, finally fell flat on 12/12/2000; and then

     Eight years ago we, as a nation, watched as Ohio de-gummed-up its system and the following day John Kerry conceded — too early by some people’s perspective (and Sorry Everybody came online); and then

     Four years ago we, as a nation, watched as the whole thing was over, at the presidential level anyway, ASAP, i.e., at 8 pm West Coast time day-of; and then

     Two days ago we, as a nation, watched and, nearly-ASAP, saw the election called at about 8:20 pm West Cost time day-of.

And then, oh my: for this just-passed election it was if we, as a nation, had tossed a coin that was weighted just a teensy bit in favor of the Dems — as just about every coin-toss of a close-one went the Dems’s way.

Now political junkies everywhere (you lookin’ at me?) can turn their attention to The Fiscal Cliff issues coming our way right soon.

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Writing of which, the Repubs can chalk up a different sort of victory — a linguistic branding victory — in the ubiquity of the very Lutz‘ian Fiscal Cliff labeling of the tax and budget issues confronting us over the next several.

In here I’ll acquiesce to my Lutz’ian master, and use that Road-Runner’y/Wile’y-Coyote’y language, though I would prefer to call it something along the lines of the ALLEL-GBTD-HSS-2001 (i.e., At Long Last the End-of-the-Line-for-the-Gimmicky-Budget-and-Tax-Deals-that-have-Held-Sway-Since-2001).

*  *  *

Part of The Fiscal Cliff we confront is a whole lot of uncertainty about tax rates — tax rates on income, tax rates on capital gains and tax rates on dividend income, to name just a few of the wild cards (estate taxes and the alternative minimum tax are also involved in big ways).

In brief, if we do indeed go off The Fiscal Cliff . . .

 

Thelma & Louise go off the cliff

 

. . . then that means that the federal government has not passed, among other things, new tax legislation before 1/1/2013, in which case all of our current tax rates will revert (that’d be the gimmicky part right there) to what they were at the end of the Clinton era, i.e., higher than they are right now and higher than they have been for the better part of a decade.

So here’s how I view this stuff . . .

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Taxes on Capital Gains.

I’ve argued for years that, when people are looking at selling an asset that’ll generate capital gains, they should consider, far more than they should have before Bush’s tax code, simply sucking it up and doing the deal in a way that results in paying the tax on that gain. Because, after all, tax rates on CGs are, by historic standards, exceedingly low (1031 industry, do you hear my call!?).

But the human being is, by and large, not wired to opt-in to an avoidable have-to-write-a-check-to-pay-it sort of tax.

But now, with that low rate possibly going buh-bye, the advice is more urgent. So maybe you should consider purposefully opting-in to paying some capital gains this year by doing some transactions by year end?

Hopefully we will know by then which way the tax-wind has blown, but we might not. So please do think it through and be ready with a plan and/or go ahead and pull the trigger. 15% is really not that bad!

A word of caution: this is tax, so there are a lot of moving parts/lots of scenarios to consider. So using your friendly tax planner/advisor might . . . pay dividends.

 

Taxes on Dividends.

Speaking of which, the conventional wisdom from mainstream media financial-talking-heads for going on five years now has been to load up on high-dividend-paying stocks. So far this advice has worked out well, in part, no doubt, due to the favorable treatment of dividend income (not to mention the doubling of the stock market since March of 2009). I mean, if you can buy still-mostly-beaten-down GE shares that over the past five years have paid an average annual dividend of 4.1%, while over that same time period 10-year Treasurys (bonds from Uncle Sam) have paid about 3%, you might well buy the GE shares, right? After all, they pay more. (And, yup, that is the way in which many, including the Wall Street Journal, spell the plural of Treasury in this context).

And how about if the money the GE shares pay out are federal income-taxed at a measly 15%, while the money the Treasurys pay out is federal income-taxed at 35% (as is often the case for well-off folks)?

Now you’re comparing an after-tax cashflow-in of 3.485% vs 1.95% (i.e., your 85% after-tax-keep of the 4.1% annual cashflow-in the GE shares have paid equals 3.485%, and your 65% after-tax-keep of the 3% annual cashflow-in the Treasurys have paid is 1.95%).

You’d accept a whole lot of downside risk from owning the GE shares knowing that your cashflow-in from holding those shares is about 75% greater than holding the Treasurys, would you?

Bond income is, then, as I tell my clients, tax-ugly, and gosh-awful tax-ugly at that.

I’ve often wondered why it is that the current tax code hates bond income so much compared to dividend income. Maybe it’s because bonds are too boring and stocks are all swashbuckling and entrepreneurial? Or maybe it’s because, in the dark hours of the sausage-making of the 2001 and 2003 tax changes, the legislative aids simply ran out of bandwidth to do more? I dunno. But I *do* know that the sausage-making also did not do any favors for annuities (though the sausage-meister did retain the primary tax-deferred, FIFO tax-beauty that life insurance products have enjoyed all these years).

At any rate, I think it’s fair to say that dividend-paying stocks have seen their prices bid up, to at least some degree, due to their tax-beauty relative to bonds’s tax-ugly.

But what have we as a nation done? We’ve gone hog-wild into bonds and are now poised for people to lose a decent chunk of money on the bonds that have been bid up by bond-buyers (and propped up by the Fed) and will eventually be bid down by bond-sellers (and plopped down by the Fed).

So maybe it’s time to lighten up on both bonds and high-dividend-paying stocks?

 

Taxes on Income.

If tax rates on income go up, there is only one obvious thing for all of us to do, and to do right away:

 

Stop making income!
Just stop it all together.

 

Just kidding.

Every bone in my body and every data point in my head — as well as my gut and intuition — tells me that increasing tax rates on income across the board (and, oh, how debatable in this context the definition of across the board has been) do not have a big impact on how people, in aggregate, work for their livings. At some of the weirder and sharper margins it might have some impact, and in individual instances perhaps, but, taken as a whole? Not so much.

Academics whom I respect just so happen to concur with me; politicians whom I do not respect just so happen to disagree with me. Funny how that works . . .

I also believe that a small increase in tax rates on big incomes (and I do think that an increase of 4.6% on top of a 35% tax rate, to get up to an overall 39.6% tax rate, is a small increase) will not, and should not, change more than a figurative handful of weirdos’ motivations for working for a living.

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Oooops . . . didn’t I open by heralding the end of the political season?

Well, its like I said before: our financial lives are inherently political.

And the tax code is one of the places where this inherent’nance is most direct!

 
 

 

1,287 words (about a fifteen-minute read sans links) (longer estimate of reading time than usual because it’s tax stuff . . . )

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