14 December 2005

Class Warfare.

Class warfare is being waged in the capital right now. But, it isn't a case of the proletariat facing off against the bourgeois. This is a war between working upper middle class families, who face a huge increase in the alternative minimum tax bills over the next several years, and the uber-rich who live on income from their taxable accounts containing stocks, who benefit from record low tax rates on capital gains and corporate dividends that are scheduled to expire in the near future.

This year's Senate tax bill would have reduced the AMT. This year's House tax bill would maintain low tax rates for capital gains and dividends. Right now the uber-rich look poised to win the latest battle, with Senator Frist announcing that the Senate is unlikely to take up AMT relief this year and may adopt an extension for low capital gains and dividend tax rates instead. But, the upper middle class, with the support of many Democrats and Senate moderates, have not given up.

While tens of millions of Americans have some beneficial ownership of investments in the stock market, this number is deceptive when you are talking about tax policy. Most Americans own most of those stocks through pension funds, retirement accounts, education savings accounts, annuities and similar tax sheltered vehicles to which the capital gains and dividend tax rates do not apply, while owning only small stakes in "ordinary" taxable accounts to which capital gains and dividend tax rates do apply (and then, usually through mutual funds, which permit smaller investments and greater diversification than purchases of individual stocks through a broker). About 2% of the households in the United States own about half of the market capitalization in the United States stock market, with much of the rest owned by institutional investors like insurance companies and pensions funds which are not impacted by capital gain and dividend individual tax rate changes. Tens of millions of upper middle class families, the vast majority of which rely on earned income and/or pension payouts to support themselves, will be impacted by the alternative minimum tax in the next few years if Congress takes no action.

Capital gains don't have to come from stocks, but most other kinds of investments have their own tax preferences. The vast majority of capital gains realized on the sale of a primary residence are excluded from taxation, and you need an exceedingly expensive property (for any place outside of San Francisco or a couple of other high priced markets) for this exclusion not to apply. Most investors in investment real estate roll over their proceeds from its sale tax free into other investment real estate using a tax break called a 1031 exchange, and often hold onto the property until death when any capital gains taxes that would have been due upon a sale are forgiven. Moreover, when investment real estate is sold and subjected to taxation, a significant share of the gain is often taxed as ordinary income to recapture depreciation deductions taken while the property was leased, rather than at capital gains tax rates, and rental income does not receive the favorable tax rates that dividend income does. Income from the sale of collectibles do not benefit from the low capital gains tax rates that are scheduled to expire in a few years if Congress takes no action. Bonds can, in theory, produce capital gains when sold, but this doesn't impact the stereotypical fixed income bond investors who take a buy and hold strategy rather than trading their bonds, and the interest from those bonds is taxed at higher ordinary income rates, rather than lower corporate dividend rates.

The current class warfare in Congress over tax policy, indeed, is to some extent a product of earlier successes from the pro-investment income crowd. By creating other tax exemptions for almost all the investment income that an upper middle class family is likely to have, they have narrowed the base of support for their crowned jewel of tax cuts, lower marginal tax rates on capital gains and dividends. The limits on the various kinds of tax preferenced savings vehicles are now so high (and the grounds upon which one can make not horribly penalized withdrawals so broad) that it no longer makes sense for even very well compensated managers and professionals to save any significant funds in taxable accounts.

None of this, of course, has any impact on the 80%+ of Americans who have no significant investment income, pay a very small share of the total fedeal income tax burden of the nation, who aren't going to be subject to AMT under any circumstances. A family of four doesn't even start to pay net federal income taxes until they hit a family gross income of roughly $30,000. The AMT, even as it impacts far more families over the next several yaers, will still affect only families with considerably higher incomes.

No comments: