At Arm's Length - Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 10.20.05

More Far-Fetched than Social Security Reform

Not that long ago, the President announced that he would spend his "political capital" to get things done that would have a major impact on how our nation functions. His first foray into rectifying programs that give Americans a feeling of economic well-being but are part of the GOP agenda for smaller government was to try and change Social Security. Fortunately, the effort failed miserably and our nation's New Deal remained viable even with the numerous flaws Mr. Bush claimed he found.

Now, the commission he appointed to study tax reform has released its recommendations to the President. With his political capital nearly exhausted, his presidential popularity at an all-time low, and with his party in disarray, is there a chance that he can make this sweeping tax proposal fly through Congress?

Let's first examine what the committee recommended. The plans they submitted to the White house on Tuesday were designed to be tax neutral. This is GOP speak for creating a plan that would keep current taxes revenues as they are now while giving breaks to those who could best generate more jobs, grow the economy, and increase the economic profile of business in this country and worldwide. To translate that into regular English, the breaks that the rich would have would stay, while the middle class would find their tax burden significantly higher. Neutral is not always even.

Over the past few years, this country has been awash in cash. The source of that money has been, in large part, from the hot housing market created by the Fed at the behest of a President who, shortly after 9/11, told the country the best way to fight terrorism was to spend. Following the fiscal irresponsibility of our elected in Washington and the low lending rate environment that followed that speech, America began to buy houses and refinance the ones they owned.

This had the net effect of increasing personal wealth while at the same time eliminating any form of national savings and increasing the amount of debt compared to both income and savings rates. We were flush with cash drawn from our home's equity and we dutifully spent it on goods we could have probably done without.

In order to accommodate the President's request to keep the income tax changes revenue neutral, the commission needed to find a way to replace the estimated $1.2 trillion that the alternative minimum tax would generate over the next 10 years. Rather than look at the previous tax cuts that were both ill-timed, misplaced and surplus depleting, the commission decided to hit the average American where they live.

The first of two plans offered for review deals directly with this nation's most popular deduction: mortgage interest rates. By proposing a cap on the amount of deductible interest based on the county average as determined by the Federal Housing Authority, a number that is adjusted monthly and based on the maximum amount the agency will insure, it will effectively eliminate hundreds of thousands of deductible mortgage dollars. The national average for FHA insurable mortgages in the United States is currently $244,000. The current deductible cap in the current code is $1 million.

That proposal would also raise the capital gains exemption on the sale of homes from the current $500k to $600k.

It doesn't stop there. Also on the chopping blocks are deductions for state and local taxes, medical and health insurance deductions (employer paid premiums above $5,000 for an individual and $11,500 for families would be treated as income and would now be taxed), charitable deductions (unless they exceed 1% of total income), IRA's 401(k) plans and a handful of other tax advantaged retirement plans (that would be replaced by savings plans designed to streamline the system and supposedly help lower income workers), and the creation of fewer tax brackets (from six to four, the lowest remaining at 15% but the highest bracket, currently 35% being replaced by a lower 33% level).

Both plans contain language concerning how investment income is taxed. The 15% capital gains tax would be extended to include interest income as well as capital gains from dividends and the sale of stock.

The second proposal offered by the committee was directed at businesses. It included lowering the dividend tax to 8.25% paid by American companies, lower the corporate tax rate (from 35% to 32%), change the way businesses depreciate capital expenditures (one plan favors deducting these outlays in the year they occur; the other allows for the deduction of interest on borrowed money for these expenditures and depreciates the purchases streamlining the corporate tax rate, in many instances lower).

If these plans seem politically divided between blue states and red states, they are. Many of the current deductions up for elimination are heavily used by blue state residents which have a significantly larger tax base - the same tax base that is triggering the alternative minimum tax to kick in for an increasing number of middle class tax payers - and higher housing costs.

If these plans seem friendlier to business and the top tier wage earner, they are. Tampering with personal retirement accounts instead of enhancing them allows many wealthier individuals to consider investments outside of traditional retirement savings because of the favorable tax environment. It also hints at the possible elimination of capital gains taxes in the near future.

Allowing business to increase their capital expenditures and creating a more favorable deduction and depreciation environment will not create more jobs. Instead, it will allow more American companies to write off foreign expenditures and expansion which will have a negative effect on job growth.

We can only hope that an election wary Congress will tell the President, who so far hasn't given the nod to either plan, to try again or leave the tax code alone. The last time revisions of this magnitude were attempted was in 1986 and it took two years of Congressional wrangling to get them passed. The key difference between now and then, we were slightly more bipartisan two decades ago.

The previous week's articles.

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