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U.S. Debt Commission: Dividends Should Be Taxed as Ordinary Income!

By Jim Fink on December 3, 2010

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I think the biggest threat we have to our national security is our debt.

Mike Mullen, Chairman of the Joint Chiefs of Staff

Our rising debt levels pose a national security threat. It undermines our capacity to act in our own interest. It also sends a message of weakness internationally. It is very troubling to me that we are losing the ability not only to chart our own destiny, but to have the leverage that comes from this enormously effective economic engine that has powered American values and interests over so many years.

Hillary Rodham Clinton, U.S. Secretary of State

This debt is like a cancer. It is truly going to destroy the country from within.

Erskine Bowles, Co-Chair of Debt Commission

On December 1st, the National Commission on Fiscal Responsibility and Reform released its final report on how to reduce the federal government’s crushing debt load.  President Obama established the debt commission back in February and charged it with the mission to “balance the budget, excluding interest payments on the debt, by 2015.” The Commission consists of 18 members – 10 Democrats and 8 Republicans – and is co-chaired by Democrat Erskine Bowles, former chief of staff under President Clinton, and Republican Alan Simpson, former senator from Wyoming

Debt Commission Report is Dead on Arrival

The debt commission is scheduled to vote today (Friday, Dec. 3rd) on whether to recommend that the final report be sent to Congress for an up or down vote.  Fourteen of the 18 members must vote “yea” for the report to be issued to Congress. According to ABC News, the report will not be recommended because at least five members have indicated that they intend to vote no.

So, that’s it right? Now that two Republicans obsessed with health care repeal and three of Nancy Pelosi’s Democratic cronies have voted it down, we can just forget about the national debt? 

U.S. Debt Crisis is Real And Growing

Wrong. The debt commission’s final report may never see the light of a congressional vote, but it is still important because it highlights a financial calamity awaiting this country if nothing is done to curtail our debt.

If U.S. debt continues to increase, investor confidence in U.S. creditworthiness will erode, causing interest rates to ramp higher, which will increase the debt even more and lead to a “debt death spiral” into the black abyss of poverty. The report clearly states that “kicking the can down the road” is not a viable alternative. Action must occur now:

If we wait ten years, CBO projects our economy could shrink by as much as 2 percent and spending cuts and tax increases needed to plug the hole could nearly double what is needed today. Continued inaction is not a viable option, and not an acceptable course for a responsible government.

By 2035, the effects will be even worse: per-capita GDP could be reduced by 15 percent! That would be a huge loss of prosperity.

Right now, “gross” public debt (including inter-government debt) is 90% of GDP and debt held by the public is 62% of GDP. Even debt held by the public will reach 90% of GDP by 2020. According to a 2010 academic study, gross public debt at 90% of GDP or higher causes a reduction in average annual real GDP growth of several percentage points. This study is based on data from forty-four countries spanning about two hundred years, so its conclusions appear robust.

Some economic commentators argue that “gross” public debt is the wrong measure and that only debt held by the public is important, which makes the U.S. debt picture look better; 62% of GDP sounds less threatening than 90% of GDP. But the fact remains that the academic study found a correlation between “gross” debt and economic growth at the 90% level, so we need to take notice now regardless of whether it makes logical sense or not.

Debt Commission Recommendations Would Help Solve U.S. Debt Crisis

If the debt commission’s recommendations were implemented, they would have a measurable impact on our debt:

  • Achieve nearly $4 trillion in deficit reduction through 2020, more than any effort in the nation’s history.
  • Reduce the deficit to 2.3% of GDP by 2015.
  • Sharply reduce tax rates, abolish the AMT, and cut backdoor spending in the tax code.
  • Cap revenue at 21% of GDP and get spending below 22% and eventually to 21%.
  • Ensure lasting Social Security solvency, prevent the projected 22% cuts to come in 2037, reduce elderly poverty, and distribute the burden fairly.
  • Stabilize debt by 2014 and reduce debt to 60% of GDP by 2023 and 40% by 2035.

Tax Reform Recommendations Are Bad for Dividends — Or Are They?

How are these dramatic improvements achieved? The report attacks the debt problem from four major angles: (1) discretionary spending cuts; (2) increased taxation; (3) health care cuts; and (4) social security reform. All of the recommendations are worth reading, but I found the tax reform recommendations most important to investors. Specifically, the report recommends that:

  • The six current tax brackets of 10%,15%,25%,28%,33%,35% be reduced to three: 12%, 22%, 28%
  • Alternative minimum tax eliminated (hooray!)
  • Itemized deductions eliminated; everyone must take a standard deduction
  • Capital gains and dividends taxed at ordinary income tax rates (boo!)
  • Mortgage interest deduction capped at a 12% tax credit and limited to mortgages worth $500,000 or less
  • Interest on newly-issued municipal bonds is taxable

The most damaging of these tax recommendations for an income investor would obviously be treating dividends as ordinary income, which would mean a tax hike from the current 15% to as high as 28%.

But this 13 percentage point tax hike looks worse than it actually would be because the report also recommends that corporate tax rates would be reduced from the current 35% to 28%, a 7% decrease. A lower corporate tax rate would allow companies to distribute more cash to shareholders, so the 13 percentage point tax hike would actually be only a 6 percentage point tax hike (13%-7%) for high tax-bracket investors. For medium tax-bracket investors, the tax impact on dividends would probably be a wash.

When one contemplates the alternative of no congressional action and dividends reverting back to the 39.6% marginal tax rate under current law in 2011, the debt commission’s proposal doesn’t look half bad.

Debt Compromise Requires Sacrifices From All of Us

I certainly am not advocating the debt commission’s recommendation of a dividend tax hike, but in the spirit of bipartisanship and national unity I am not willing to denounce the plan because of it.  Reducing our national debt demands sacrifices from all of us. That is what compromise is all about.  If everyone rejects the plan because there is a provision that hurts them, nothing will every get done. The “not in my backyard” mentality got us into this financial mess to start with. As the report states:

None of us likes every element of our plan, and each of us had to tolerate provisions we previously or presently oppose in order to reach a principled compromise. We were willing to put our differences aside to forge a plan because our nation will certainly be lost without one.

We do not pretend to have all the answers. We offer our plan as the starting point for a serious national conversation in which every citizen has an interest and all should have a say.

Let the conversation begin! The greatness of our country depends on a compromise solution being reached soon.

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