Senate's Tax Pact Is Much Ado About Nothing

The magical disappearing tax break may be a fine way for the Senate to conjure up something of a compromise, but the effect it will have on the economy is more a matter of smoke and mirrors.

When the Senate voted last week to approve a $350 billion tax cut, it included some revenue-raising (read: tax increases) to offset the cost of eliminating the tax on dividends -- a provision for which President Bush desperately lobbied. To minimize the cost of the president's proposed $400 billion dividend cut, though, the Senate also limited the dividend tax relief to a three-year period.

"It doesn't make a lot of sense," says Jim Cusser, who manages a $1.5 billion bond portfolio for Waddell & Reed and has long advocated for the elimination of a tax on dividends. "Any temporary tax reduction typically goes to savings. But this way the president gets a legislative victory, although it won't do what he intended it to do."

According to the Senate's latest proposal, only half of dividends distributed in 2003 will be taxed; in 2004, 2005 and 2006 no dividends will be taxable at the individual's level. In 2007, though, the break expires, or reaches its sunset, and the tax law reverts back to its current state -- in which all dividends are taxable at the individual's ordinary income tax rate.

Congress has taken to phasing in tax breaks and adding these sunset provisions in an effort to hide the true cost of budget expenses -- such as tax cuts. And the 10-year projections that are so common in Washington these days are really nothing more than an outgrowth of that same desire to delay the real accounting of a tax cut.

"In the early 1970s we had one-year budget forecasts," says Stan Collender, managing director of Fleishman-Hilliard's federal budget group. "That went to two years when Congress realized all they had to do to get the amount they wanted was to push past the standard projections. Two years became five, and five became 10."

And the psychics -- or "economists," as they're generally called in Washington -- are faced with more and more daunting forecasts. "The longer you get out beyond one year, the worse it gets, because we don't know how to do it," Collender says. "There's nothing to indicate that the 10-year mark is sacrosanct. It's just a nice round number."

But it's not just a matter of the alchemy -- it's also the ingredients. The White House, Senate, House of Representatives and private forecasters are all generally working with different assumptions. To even begin to gauge a tax cut's impact on the economy, Collender says, everyone has to agree on a methodology, time frame and all the underlying factors. "And on a scale of one to 10 of that happening," he says, "I'd give it a negative two."

Anybody's Guess

We're still several weeks away from an actual tax bill (when the Senate and House reach an agreement), says Greg Valliere, managing director of Charles Schwab's Washington research group, but it seems that no compromise will have anything more than a short-term effect on the economy -- assuming it has any effect at all.

"Whatever they eventually come up with will look gimmicky," Valliere says. "With all the phase-ins and sunsets, investors are going to look at the bill with skepticism."

The one thing that may provide some sort of short-term relief, though, is the acceleration of the breaks that have yet to be phased in from the 2001 tax law. But while those scheduled breaks will likely happen faster as a result of the new bill, they're still subject to the same sunset provision in the 2001 law -- which means they'll expire in 2011.

Even so, the boost in the child tax credit (likely to go from $600 to $1,000) and some marriage penalty relief should put some money back in taxpayers' pockets, even if it's just a short-term break. Then again, such short-term tax savings generally end up as just that -- savings, rather than spending that fuels the economy.

The dividend tax cut, though, won't matter much as it stands now in the Senate's plan.

"We're not going to see a big payout of dividends because of this," says Cusser of Waddell & Reed. "Making it a three-year thing won't change the motivation of corporations or change the behavior of individuals -- even if it is expected to be renewed in 2007."

Some are more optimistic as to the stimulative nature of the Senate's dividend tax cut. "The dividend proposal will have behavioral effects," says Leslie Samuels, a partner at law firm Cleary Gottlieb and former assistant secretary for tax policy under President Clinton. "Companies will delay payments of dividends for the remainder of this year, and investors will see bigger payments next year. If they don't do that, shareholders will be upset."

While Samuels agrees with the consensus in Washington that the House plan -- which lowers the tax on dividends and capital gains to 15% -- makes more economic sense, he says it's likely President Bush will back the Senate's version anyway. "That way he can claim victory," Samuels says. "He'll have a better sound bite."

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