Jeremy Siegel, Ph.D. The Future for Investors

Revised March 4, 2008

In November 2004, President George W. Bush basked in victory as he won his second term as president and strengthened the Republican grip on Congress.  After the election, many of his advisors recommended that Bush use his political capital to press Congress to make the tax cuts permanent that his administration enacted over strong Democratic opposition in 2001 and 2003.

Instead Bush decided to pursue reform of the Social Security System, a policy initiative that he touted during his campaign. It is a policy decision policy that Republicans will regret for many years.  

The Bush Social Security initiatives went nowhere.  With the 2000-2002 bear market fresh in voters minds, future retirees were not interested in having the government put stocks in the Social Security Trust Fund or worry about funding their own “private accounts” to assure their retirement.    

The two years Bush spent pursuing this failed project were extremely costly. With the Iraq War festering and Bush’s popularity plunging, the Democrats swept Congress in 2006 and suddenly there was no hope of making tax cuts permanent.

The Bush Tax Cuts

Let us review tax history to understand the current dilemma the Republicans find themselves in. The Economic Growth and Tax Relief Reconciliation Act of 2001 (or EGTRRA), passed during Bush’s first year in office, was wide-reaching.  It lowered individual income taxes for all taxpayers by restructuring tax rates and brackets, increasing the child credit and dependent care credit, providing relief from marriage penalties and the AMT, and increasing the earned income credit for married couples.  Specifically the Act lowered the top income tax rate from 39.6% in stages to 35%, where it stands today.

Because the Congressional Budge Office had projected that this tax cut would widen the budget deficit, some Republicans (including the current presumptive Republican presidential nominee John McCain) opposed making the cuts permanent and Bush had to settle for a law where all the tax cuts will expire (or “sunset,” to use congressional lingo) in 2011.

As the economy strengthened and fear of deficits waned, Bush was able to pass a more ambitious tax package two years later. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) raised the AMT exemption and accelerated the pace at which provisions of EGTRRA, particularly the lower tax rates on earned income, phased in.

Importantly, the 2003 act also reduced the maximum tax rate on capital gains from 20% to 15% and reduced the tax rate on qualified dividends (dividends from corporations excluding Real Estate Investment and other trusts), from as high as 35% to a maximum rate of 15%.  This was the first time that that tax code seriously addressed the “double tax” on dividend income, so called because corporate profits are taxed first through the corporate income tax and then taxed again at the personal level when paid as dividends. The provisions of the 2003 Act were set to expire in 2009, 2 years earlier than the provisions of the 2001 Act but the Tax Increase Prevention and Reconciliation Act, passed in 2006, extended the lower dividend and capital gains tax rates to 2011.
 
Inaction Means Higher Taxes

If no new tax laws are passed, all taxes will revert to the higher rates that existed at the end of the Clinton presidency and there will be no relief from the double taxation on dividends.

This means that with the Democrats all but certain to retain control of both houses of Congress this November, the Democrats can “repeal” the Bush tax cuts just by doing nothing.  Our future taxes are now in the hands of a Democratic Congress no matter who takes the presidency.

Current Candidates Positions

John McCain wants to retain the lower tax rates in the current law, but even if he is elected president, he cannot unilaterally do this without Congress’ approval.  However, if a Democrat wins the White House, it is far more likely that his or her plan will shape the new tax law. Currently Hillary Clinton has recommended that the top capital gains tax return to the 20% level it was before the 2001 Bush tax cut and that the reduction in the tax rate on dividend income be entirely eliminated.  

Barack Obama, on the other hand, wants the maximum tax rate on dividends and capital gains to rise to 24%, but he recommends no tax on capital gains from start-up companies.  Ostensibly this stems from Barack’s support for the job-creating power of small businesses, but it should also be noted that he has received some very strong sponsorship from venture capitalists, particularly in the technology area.

Both Clinton and Obama have strongly supported a return to the 39.6% tax rate on top income brackets that prevailed before the Bush tax cuts.  Interestingly, both Democratic candidates are considering a cut in the corporate tax rate, which at 39% (federal tax rate plus the average state tax rate), is the second highest in the developed world after Japan.  Representative Charles Rangel (D-NY), chairman of the tax-writing House Ways and Means Committee and hardly a tax-cutting advocate, has already recommended lowering that rate to 30%.

The Best Plan

Of the two Democratic candidates’ plans, Obama’s is better.  The double taxation of dividends is a much more serious economic drag than whether the top capital gains tax rate is 20% or 24%.  As the baby boomer generation enters retirement, they will be increasingly reliant on dividend income to supplement social security income and increasing medical costs.  Furthermore, before the 2003 Act, the US had one of the highest tax rates in the world on dividend income.  There is no reason for the US to go back to that policy.

But a word of caution about Obama’s tax policy.  He has also supported the elimination of the cap (currently  $102,000, and indexed to wages) on earned income for the computation of the social security tax. This means that the full 12.4% social security tax (6.2% employee plus 6.2% employer and 12.4% for self-employed) will apply to all earned income, raising the effective rates of high wage earners to nearly 50%, one of the highest in the world.

The best policy would be to keep all tax rates low, eliminate most of the deductions and exemptions that complicate our tax code and drain revenue, and restrain the uncontrolled growth in government spending.  Many of the new developing countries, particularly in Eastern Europe are adopting low uniform tax rates, finding that they collect more taxes at low rather than high rates through reduced tax evasion and less tax avoidance.  The Bush tax cuts of 2001 and 2003 brought in significantly more tax revenue than had been predicted at the time they were enacted.  Even if the Democrats control of all branches of the government next year, these are facts that they should not ignore.