Updated from 12:29 p.m. EDTWe've all been taught to think of compromise as the noble endeavor to reach a mutually agreeable solution. Leave it to Congress to work toward another meaning -- compromise as a mishmash of ideas that provide no solution. Thanks to some final wrangling Wednesday night, Congress is expected to agree upon a tax-cut package Friday. After months of squabbling over how much of President Bush's $726 billion tax-cut plan should be included in the budget (estimates ranged from zero in the Senate to $726 billion in the House), congressional leaders have pulled elements from each of their plans to arrive at an ad hoc tax plan that still could change at any moment. (Click
Half Measures for InvestorsBut the real strangled compromise shows up in the provision that provides a break for investors. President Bush has advocated a total elimination of the tax on dividends for individuals, a plan that also included an implicit capital gains tax break and would have cost some $396 billion. Investors eagerly awaiting that boondoggle, though, will be sorely disappointed. The Senate gutted that idea when it voted to keep the tax cut to $350 billion, but last week Republicans tried to wring some sort of victory by eliminating the tax on dividends for three years. Such so-called sunset provisions are frequently used by Congress as a sort of half-measure. They allow for expensive tax policy by limiting the number of years the tax break is effective. The burden is then on future lawmakers to extend the break or the tax law will revert to what it was before the new provision.
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."