Wall Street’s big rally sharpens focus on tax

Expiring tax breaks for dividends will be in the spotlight for the rest of the year thanks to Wall Street’s rally and record budget deficits.

And that’s expected to lead to a battle among Democrats over how to tax corporate profits paid to shareholders.

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President Barack Obama has proposed that the current rate of 15 percent on dividends be extended for most taxpayers. He’d raise the tax on dividends for individuals making $200,000 or more and families making $250,000 or more to 20 percent.

There are several reasons to think wealthier taxpayers will get hit with a much higher tax.

The first is the pay-go law approved by the House. It foresees taxing as ordinary income the dividends earned by individuals and families above the income thresholds set by the president.

That would result in dividend income being taxed at a maximum rate of 39.6 percent next year for people in the top tax bracket, more than twice the current tax rate.

Under pay-go, lawmakers who want the tax to be lower will have to come up with ways to offset the income with either spending cuts or other tax increases, a tough hurdle to meet.

That pay-go law also reflects the politics of the House.

Many Democrats want to tax richer people’s investment income at a high rate; otherwise, the pay-go language would not have been written and approved. Those arguing for a lower tax would have to battle those who want to do away with this George W. Bush-era tax cut.

The language also suggests much of the Democratic caucus is comfortable with the line Obama drew in his 2008 campaign between the middle class and the rich. By saying that he would not raise taxes on families making more than $250,000, Obama effectively defined “wealthy” as those who live above that line.

A second reason for dividend earners to worry is the record budget deficits, which have Washington looking for additional revenue from anywhere money is available. 

Federal Reserve Chairman Ben Bernanke, Obama economic adviser Paul Volcker and House Majority Leader Steny Hoyer (D-Md.) have all said higher or new taxes will have to be part of the mix of solving the budget deficit, along with spending cuts and entitlement-program reforms.

It’s not hard to see why. The country faces a $12.8 trillion debt, and though a Treasury Department report released Monday showed this year’s budget deficit is smaller than expected, it still stood at $1.3 trillion.

An estimate of the revenue raised by taxing dividends as ordinary income has not yet been released. Obama’s 2008 budget, however, estimated that the Treasury would raise $5.4 billion in 2011 by taxing dividends and capital gains at 20 percent for individuals with incomes above $200,000, and families above $250,000.

Finally, the lesson of the expired estate tax also has dividend-tax watchers nervous.

Congress was expected to extend the estate tax last year, but instead let it expire when Republican and Democratic senators could not reach a compromise. The estate tax is set to kick in again in 2011 at a much higher rate if no action is taken this year.

Jim Owen, a spokesman for the Edison Electric Institute, a major player in the dividends debate, acknowledges there’s concern that Congress will not take action on the dividend tax given what happened last year on the estate tax.

“Are we concerned about that? You’d always be concerned, but I don’t think it’s got to the point of panic,” said Owen. “That’s why we’re vigorously involved in this.”

That said, there are reasons to think a compromise will win out as well.

Not every House and Senate Democrat agrees with Obama’s definition of who can afford more taxes.

Opinions tend to vary by congressional district, Democratic aides told The Hill this week.

Some centrist Democrats are also concerned about over-taxing investment income.

An increase in taxes on dividends would follow a separate tax on the investment income of high earners that was included in the healthcare law.

Specifically, that new law includes a 3.8 percent Medicare surtax on capital gains and dividend income for those making at least $200,000 (individuals) or $250,000 (families).

Significantly, the New Democrat Coalition, a pro-business caucus of centrist Democrats, many of whom represent suburban areas, has not taken a position on how dividend income should be taxed.

One of its members, Rep. Ron Klein (D-Fla.), in a March 1 op-ed to The Hill, called on tax rates on dividends to be kept low, but did not explicitly state what rates should be for upper income earners.

Experts following the issue closely believe the most likely outcome is a compromise that would tax dividend income on wealthier Americans at a rate between 15 percent and as ordinary income.

But this could be reflected in dozens of ways, including graduated increases in tax levels based on income to a phased-in system in which taxes on dividends would rise over time.

All of this suggests the dividends tax fight will be a long and complicated one that has the potential to drag into the election season.