Compromise Tax Plan Falls Short

The new plan takes the Senate's sunset provision but essentially applies it to the House's plan. The House wanted to lower, not eliminate, the tax on dividends to 15%. Currently, dividends are taxed at the same rate as ordinary income: If you're in the 27% income tax bracket your dividends are taxed at 27%. If you're in the 38.6% bracket, your dividends are taxed at 38.6%. The new plan, though, would fix the tax on dividends at 15% regardless of what tax bracket investors are in.

Long-term capital gains -- profits made on securities held more than a year -- will also be taxed at the new 15% rate. Currently, long-term capital gains are generally subject to a 20% tax. The tax on short-term gains, which is currently equal to the investor's ordinary income tax rate, remains unchanged in the new plan.

Because the president has been agitating for the elimination of the tax on dividends for several months, the break will be effective retroactively to Jan. 1, 2003. But since the House first introduced the idea of a capital gains tax reduction on May 5, 2003, only gains after that date will be eligible for the 15% rate.

The low rate on dividends and capital gains will only be in effect through 2008, though. In order to eliminate the tax on dividends completely for three years, the Senate had included in its plan a dozen or so "revenue raisers" that would offset the money spent on the tax cut. But those all fell out of the joint plan, so the only way to squeeze in a dividend tax cut (and still keep it to the $350 billion minimum required to pass the Senate) was to keep the Senate's idea of a short-time horizon and the House's idea of simply lowering the rate to 15%, but also lowering the rate on capital gains to 15%. (The initial House plan did not have a sunset provision.)

But here's where some political savvy sneaks in: In keeping with current law, there are additional provisions for investors in the two lowest income tax brackets. Investors in the 15% and 10% income tax brackets will pay just 5% tax on their dividends through 2007, and in the last year of the bill will not owe any tax on dividend income or on capital gains.

That sounds great for the little guy, but is virtually a sop to the rich. Taxpayers in the lowest brackets report virtually no income from capital gains or dividends. "It doesn't cost them anything to include this proposal," Oschenschlager says, "and it establishes the principle of zero tax on investment income."

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