Starting January 1, 2011, Washington Democrats will impose a $3.8 trillion tax hike on hard-working Americans.  This tax increase will affect every American who pays income taxes through higher tax rates on individuals, families, and small businesses. 

As described below, Washington Democrats are targeting investors who provide the capital to help businesses grow and create jobs for much higher taxes starting next year, at a time when businesses are struggling just to meet payroll and the unemployment rate remains near ten percent.

For investors: 

• The top statutory tax rate on capital gains will go up by one-third in 2011, from 15% to 20%, with further increases in 2013 as a result of the recently enacted health law.
• The top statutory tax rate on dividends will go from 15% to 39.6% in 2011 and, with hidden taxes and other tax increases set to take effect in just a few years, the top effective tax rate on dividends will more than triple by 2013.   

Together, these tax increases on investments will directly affect more than 26 million taxpayers, who will pay an average of $1,240 more in higher taxes in 2011 alone.  About one-third of the affected taxpayers will be senior citizens, who will pay an average of $1,700 more in higher taxes next year. 

Moreover, millions of other savers, investors, and workers who don’t pay capital gains or dividend taxes will be indirectly affected by this tax increase.  First, this tax increase will reduce the value of stocks, even those held in tax-preferred accounts like IRAs and 401(k)s, by making stocks a less attractive investment alternative.  Second, economist Allen Sinai authored a September 2010 study that measured the impact of a higher capital gains tax rate on employment.  Dr. Sinai found that increasing the capital gains rate from 15% to 20% would destroy 231,000 jobs annually.

And of course, that is not the full extent of the Democrats’ tax increase.  Part I of this series provided an overview of all the tax hikes, while Part II provided examples of how they will affect typical taxpayers.  Part III discussed further the impact on middle-class families.  Part IV explored the higher taxes facing senior citizens and Part V looked at how it will impact the engines of job creation, America’s small businesses.

Below are details about how the looming tax increases on capital gains and dividends will hurt investors and the economy. 

* Because of the reinstatement of additional, hidden tax rates (see Part I of this series), while the top statutory long-term capital gains rate will be 20% in 2011, the top effective rate will actually be 22%.  For dividends, while the top statutory rate will be 39.6% in 2011, the top effective rate will actually be 41.6%. 

Further note that, under the Democrats’ new health law, beginning in 2013, investment income will be subject to an additional 3.8% surtax for single taxpayers earning more than $200,000 and married couples earning more than $250,000.  This will bring the top statutory rate on long-term capital gains to 23.8% and the top statutory rate on dividends to 43.4% in 2013.  Because of the additional, hidden tax rate increases described in Part I of this series, however, the top effective rate on long-term capital gains will be 25.8% in 2013, and the top effective rate on dividends will be 45.4%.  These effective rates are significantly higher than the maximum 20% rates that President Obama and Treasury Secretary Geithner claim to support.  Ways and Means Committee Ranking Member Dave Camp recently asked Secretary Geithner for clarification of this issue.

THE DIRECT TAX HIT

Recent data from the non-partisan Joint Tax Committee confirms that this tax increase will impact 26 million taxpayers (the definition of a “taxpayer” includes individuals and families filing joint returns, so the number of people directly affected by this tax increase is much higher).  On average, these affected taxpayers will pay $1,240 more in taxes – just in 2011 – as a result of these higher rates on dividends and capital gains.  As noted in Part IV of this series, the burden is especially heavy for the 8 million senior taxpayers directly affected, as their average tax increase in 2011 will be $1,700.

WHO RECEIVES DIVIDENDS AND CAPITAL GAINS

Contrary to the image of some that only a wealthy few Americans receive dividends and capital gains:

• A recent study by Ernst & Young found that 65% of dividends were on tax returns with total income under $100,000 and 36% were on returns with total income under $50,000.
• The Tax Foundation, looking at 2008 data, confirmed seniors are especially reliant on dividend income.  Even though they filed roughly one-third of tax returns showing dividend income, seniors earned just under half (48%) of all dividend income.
• With respect to capital gains, the Tax Policy Center recently projected that in 2012, about 12.6 million tax returns will include income from long-term capital gains.  Of that number, nearly 6 million will be filed by taxpayers with income under $100,000 and nearly 10 million will be filed by taxpayers with income under $200,000.  

These are the taxpayers just months away from a massive direct tax increase on investment income.

TENS OF MILLIONS MORE LOSE INDIRECTLY VIA FALLING STOCK PRICES

Tens of millions of other Americans who don’t receive taxable capital gains or dividend income stand to be substantially affected by the 2011 tax increase on investment income.  That is because even tax-exempt investments, such as IRAs and 401(k)s, will see their value reduced when investment taxes increase.

Barclay’s Capital has estimated that increasing taxes on dividends and long-term capital gains will cause the equity markets to fall by more than 8%.   Barclay’s further cautions against the assumption that these dangers can be avoided by “only” imposing those higher taxes on “the rich”:

“From a behavioral standpoint, if the [Obama Administration] follows through on its plan to raise dividend and capital gains taxes for the highest income earners, it could influence the asset allocation decisions of an important investor class and potentially bring about a shift away from equities, with negative knock-on effects for the economy.”  

Many Americans who are invested in the stock market though tax preferred accounts do so though mutual funds.  According to the Investment Company Institute, more than 50 million U.S. households are invested in mutual funds, representing about 43% of all U.S. households.  So while some of those investors won’t pay higher taxes as a result of the tax rate increases on dividends and long-term capital gains (because they hold the asset in tax-preferred accounts), the resulting downward pressure on their investments is something families struggling to prepare for retirement can ill-afford.

HIGHER TAXES ON DIVIDENDS ARE ESPECIALLY BAD POLICY

From a broader perspective, the proposed tax increases will encourage businesses to finance their operations in ways that may undermine their stability.  That is because employers that borrow money to finance their operations can deduct the interest costs, and investors generally pay tax on the interest income.  Thus, debt financing is subject to a single level of tax.

By contrast, companies do not get a deduction when they pay dividends, so they must pay them out of after-tax profits.  Then, the dividends are subject to a second level of tax in the hands of the individual investors. Tax changes made in 2003 helped reduce this double taxation by capping the maximum rate of tax on qualified dividends at 15%. 

The Democrats’ planned tax increases would increase the tax advantage of debt financing over equity by increasing the effective tax rate on equity.  By increasing the after-tax cost of financing business operations with debt but leaving unchanged the after-tax cost of borrowing, employers would have even more incentive to rely on debt-financing. 

While there are many reasons employers might choose one form of financing over another, the tax consequences should not be one of them.  But by further encouraging debt financing, the Democrats’ 2011 tax increase will increase incentives for businesses to load up on debt, making them more vulnerable to bankruptcy in a future economic slowdown.  

Similarly, raising the top tax rate on dividends would also deny the financial markets an important signal about the health of businesses.  That is because, as former Treasury official Bob Carroll has noted:

“The payment of dividends also may improve corporate governance by providing an important signal to investors of a company’s underlying financial health and profitability. Generally, a firm cannot be expected to pay dividends for a long period of time unless the company has earnings to support such payments. Regular dividend payments also limit funds over which corporate managers have discretion and may be one way for shareholders to ensure that managers invest only in projects that raise shareholder value.”

CONCLUSION

Higher taxes on capital gains and dividends are a bad idea across the board.  They will directly increase the taxes paid by 26 million taxpayers.  They will also indirectly hurt millions of other investors by reducing the value of their investments and hundreds of thousands of workers by eliminating their jobs.  And the higher taxes on dividends threaten to reintroduce unneeded distortions into firms’ financing decisions and corporate governance. 

Perhaps that is why 47 House Democrats signed a September 24, 2010 letter to Speaker Pelosi pleading with her to extend the lower rates on investment income.  In the letter, these Democrats stated:

• “By keeping dividends and capital gains tax rates linked and low for everyone, we can help the private sector create jobs and allow seniors and middle class households to save and invest more.”  
• “A dividends tax increase would impede our nation’s economic recovery.”
• “These outcomes would disproportionately affect seniors and those saving for retirement… Many seniors depend on this income to supplement their fixed retirement income.”

These higher taxes are bad for investors, bad for employers, and the Congress ought to defuse this ticking tax bomb before it is too late.

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