Time To Start Preparing For Expiration of Bush Tax Cuts?

The Republican Party is fumbling the ball during this quarter of the campaign season. If they don't come up with a better game plan soon they will have blown a golden opportunity to take control of all three branches of the Federal government. And if the Democrats hold on to the Senate or the Presidency, the Bush era tax cuts are likely to be allowed to expire. Expiration of the Bush Era tax cuts would lead to higher taxes on both income and investments. While the sections of the legislation impacting income tax rates and deductions may be extended, it seems very unlikely that the reductions on capital gains and dividends would be extended by a  Democratic Senate or a second term President Obama.

The two major tax cutting laws passed during the Bush era were the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Jobs and Growth Tax Relief Reconciliation Act of 2003.These two bills cut taxes for earned income, long-term capital gains and dividends. The legislation also expanded the child tax credit and made dozens of other changes and adjustments to the tax code, involving exemptions, deductions and the marriage penalty. While this post is focused on the impact of expiration of the reductions on capital gains and dividends, a review of the changes to tax rates and deductions is provided in a Forbes article on How Will The Expiring Bush Tax Cuts Affect You?

Capital Gains/Dividends
The maximum tax rate on long-term capital gains and qualified dividends was reduced to 15% by the tax cuts. The sunset provisions would return the capital gains rate in 2013 back to a maximum of 20%, and qualified dividends would resume being taxed at the regular tax rate of the filer of as high as 39.6%.

Anticipation of an increase in the long term capital gains tax from 15% to 20% in 2013 would probably be enough by itself to guarantee that the stock market would not have an end of year Santa Claus rally in 2012. A 5% increase in the capital gains tax would lead to sales of investments with capital gains originally planned for early 2013 being pushed back into 2012. However, an increase in the tax rate of dividends could be a much bigger market mover. In particular, it would hurt the price of dividend paying stocks. The impact would vary from stock to stock depending on how much of the market capitalization was based on the dividend yield, but some stocks with high dividend yields might drop in price by 5% or more. The increase in tax rate on dividends from 15% to as high as 39% would reduce the net income available via dividends and make these high yielding stocks less attractive to investors. It would lead to 2012 being the opposite of 2011, a year in which stocks with high dividend yields led the market upward. A decline in high dividend yielding stock prices would weigh heavily on the entire stock market.

If the Republicans will be in trouble in November if they continue to:

1. foolishly focus on a class warfare message
2. turn the campaign for the Presidential nomination into a circular firing squad

The class warfare message is not going to win many voters over to the Republican cause. According to a recent Wall Street Journal/NBC poll 79% of independent voters agree with the statement that the U.S. is "out of balance and favors a very small proportion of the rich over the rest of the country." Further, the class warfare message does not exactly deliver an emotional jolt. Proposals to impose increased taxes on the rich is not exactly a call to send them to the guillotine. Heck, the majority of American voters are not going to get even a tiny bit upset about the fact that the rich may have to pay more in taxes.

The class warfare message can easily be turned against the Republican party. It falls in line with a perception  that the Republicans pander to the rich. Given the size of the budget deficit and the declining real income of most U.S. families, it won't be hard to garner populist support for a "millionaires" tax. 

The bitter attacks being made by the Republican Presidential candidates upon each other is weakening all of them. None of the current Presidential candidates will provide the rest of the party with coat tails in November. Mitt Romney was only viewed positively by 24% of Americans in a Wall Street Journal/NBC poll taken last month, and his rating may be even lower after all the press coverage and attacks upon his Cayman Island holdings. Newt Gingrich is viewed even less favorably than Romney according to polls conducted by CBS news and the New York Times. Further, a poll conducted by Fox News showed that voters who disliked Newt Gingrich outnumbered those who did like him by a two to one margin.

Conclusion

The weak campaign being run so far by the Republican party and their Presidential candidates is reducing their likelihood of taking over all three branches of government. Continued Democratic control of just one of the three branches of the federal government would make an extension of the Bush era capital gains and dividend tax cuts unlikely. Investors should prepare for how the stock market would react to this change and how it will impact their after tax income. Much can happen between now and the November election, so no immediate action is required, but don't get caught off guard by the possibility of the Bush era tax cuts expiring.

Related Posts

Romney Is Badly Misplaying His Private Equity Experience

Beware of Little Old Ladies With Signs - Why The Tea Party Should Compromise on NO New Taxes