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Determining tax policy and the definition of insanity

December 29, 2012
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This time of year is a great time to watch college football and take part in the bowl season. One of the bowl contests has been covered more on CNN and Fox News than ESPN. It is the Fiscal Cliff Bowl, and the two-minute warning has been issued. All the participants are in hurry-up mode and the final play needs to be called.

A number of questions come to mind. Will there be an end run around higher tax rates? Will the 15 percent tax rate for qualified dividends get sacked? Will anyone call time out before the clock runs down? Will there be overtime?  

Unfortunately the fiscal cliff isn’t a college bowl game, but real life. Politicians, to some degree, are messing with taxpayers’ finances and the government’s financial future.

The on-again and off-again bargaining between the respective parties in Washington has left many with a bad taste in their mouth — and it isn’t from old, leftover eggnog from the holidays.

Many of the tax provisions at issue in Washington actually expired Jan. 1, 2012, and there are other provisions set to expire Jan. 1, 2013. The list of expired and expiring provisions has been a known quantity since the last tax showdown nearly two years ago in December 2010. As no surprise to many in 2012, the result was last-minute negotiating and a rush to avoid the negative consequences of falling off the cliff.

Many companies and taxpayers rushed to make decisions with respect to whether to take actions such as to accelerate income, deductions, make gifts and consider other planning before the clock runs down to zero. There was a flurry of announcements in November and December regarding year-end dividends, special dividends and accelerated dividends by many public companies, including many recognizable names. The potential tax-savings impact is large for many investors: the difference between a federal marginal tax rate on certain dividends of 15 percent in 2012 and a possible rate of 43.4 percent in 2013. So there is an actual potential tax (and cash) benefit of receiving a dividend in 2012 over receiving it in 2013.

For those public and private companies that did make the decision to pay a dividend in the final days of 2012, the impact on tax revenues may be interesting. Will tax revenues be lower than expected in 2013 because of the income acceleration in 2012? And will companies reduce or not pay dividends in 2013 or following years? And, will companies consider stock buybacks to provide their shareholders with the favorable long-term capital gains tax rates rather than using the cash to pay a dividend that will be subject to a tax rate 20 points or more higher than a capital gain? 

For companies that do pay dividends, will the rates of increase of annual dividends slow down because of the higher individual tax rate on the dividends? Since 2003, when the reduced rate on qualified dividends was enacted, the rates of growth on dividends for many companies increased as a result of both earnings growth and the tax rates or the investors in the shares of the companies.

Other taxpayers will be impacted for 2012 (and beyond) if the Alternative Minimum Tax patch isn’t extended. The patch is needed as the AMT exemption amount will reset to the level from the 1980s. If it isn’t enacted, most middle- and upper-income taxpayers will see a significant tax increase for 2012, for which payroll withholding and estimated tax payments have likely not been considered for the 2012 tax year.

Business taxpayers are interested in whether the research credit will retroactively be enacted for 2012. The research credit expired at year-end 2011, and thus, under current law, there is no credit available for 2012 unless the research credit is extended for the 2012 tax year. If the U.S. doesn’t renew/extend the credit, it will be in a small minority of countries without a tax incentive for research.

There has been much debate on economic theory and taxes and the impact on the economy. Do higher or lower taxes really impact economic growth and tax revenue? Many politicians and pundits like to cite the budget surpluses and economic growth of the late 1990s as evidence that tax rates can be high and still generate significant revenue and a booming economy.

A couple of points of fact (from my point of view) should be mentioned with respect to these assertions. The country was in the height of the dotcom bubble with large capital gains (and capital gains tax revenues even after reducing the capital gains tax rate from 28 percent to 20 percent in 1997). Also, recall that oil prices were in the ballpark of $10-$12 per barrel, not the $80-$100 level we see today. As a result, gasoline at the pump was less than $1 a gallon. The difference in oil prices alone is the difference of more than $500 million a day in savings to the U.S. economy in reduced foreign oil purchases (in dollar terms). And, lastly, the U.S. was not funding any wars or military conflicts at that time, so there wasn’t that drain on the U.S. Treasury.

The long-term impact of the uncertainty of the events leading up to and resolving any fiscal cliff issues may never be exactly determined with any precision. It is difficult to measure what investment or spending decisions were not made by the private sector amidst all the hoopla and uncertainty. Once more, the current efforts only temporarily extend some issues and don’t resolve them. We may repeat the fiscal cliff exercise all over again in a short amount of time.

Albert Einstein is quoted as saying that “insanity is doingthe same thing over and over again and expecting different results.” Who would have thought that insanity may come into play in determining tax policy.

William F. Roth III is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily of BDO. The comments are general in nature and not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult their professional advisers before acting on any items discussed.

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