Don't Mess With Taxes

One again, politics trumps policy.

Rather than work toward a tax bill that includes breaks for most of us, Congress apparently has decided to focus on pet projects to benefit wealthier taxpayers: capital gains and estate tax cuts.

And by Congress, I mean the Republican leadership that controls what bills are considered when. This Bloomberg.com article, Republicans Set Aside Middle-Income Tax Cuts to Focus on Rich, cuts right to the chase:

"Six months before elections that may return a Democratic majority in at least one house of Congress, Senate Majority Leader Bill Frist of Tennessee and House Speaker Dennis Hastert of Illinois are focusing on extending the 15 percent rate on investments and repealing the estate tax. They won't push extensions of lower rates for all taxpayers and expanded breaks for married couples and families with children, which expire after 2010."

Congress has been struggling with all manner of tax legislation since last year (as noted in this December blog entry), when several of the breaks officially ended.

Now, half a year later, lawmakers have separated the various expiring provisions into two packages (discussed in more detail here). The estate tax component isn't in either of these bills, but, as the Bloomberg report notes, expect action on it well before some of its most ardent supporters find they no longer have jobs on Capitol Hill.

The tax treatment of capital gains and dividends, however, is the cornerstone of the tax bill now getting Congress's full attention.

To be fair, these lower rates aren't limited to just the wealthy. More and more of us invest in stocks and mutual funds and we have been reaping the benefit of the cut from 20 percent to 15 percent (or, for lower-income taxpayers, 10 percent to 5 percent) for the last few years.

And the bill extending the preferred tax treatment of investment earnings does include some relief from the alternative minimum tax. Lawmakers have included changes that would save around 15 million taxpayers from having to pay this costly parallel tax (details on how it works here) on their 2006 income.

But the tax pattern is clear.

According to the IRS, 43 percent of the taxpayers who took advantage of the lower capital gains and dividends tax rates earned at least $1 million.

The estate tax figures are even more skewed. A federal after-death tax bill will affect only those who leave more than $2 million in assets, a number that the IRS expects in 2006 will be fewer than 13,000.

On the other side of the tax stats, the Tax Policy Center says that 70 percent of those claiming the child tax credit earned less than $75,000. And more than half of the taxpayers who saw their tax bills drop because of the income bracket changes that eased the marriage tax earned less than $100,000.

Not only is this legislative approach blatantly inequitable in its lack of consideration of consequences for all taxpayers, it's just plain bad policy, regardless of which political party controls Washington. Unfortunately, America is a reactive country and our tax laws are no exception.

Instead of dealing with an inherent tax problem and fixing it for good, the political nature of lawmaking encourages Capitol Hill to deal with one aspect and craft a short-term, piecemeal solution.

Such smaller, bite-size tax breaks are easier for voters to swallow. And too often, we constituents just gobble them down without ever thinking about whether they really are good for our personal or the country's overall, long-term economic health.

The following list, compiled by the Tax Foundation, assumes the estate tax phaseout schedule will remain as originally passed and the capital gains and dividends measure will pass. Under this scenario, the coming cost of such politically-based, short-term legislation will be glaringly evident on Jan. 1, 2011, when all these tax chickens -- turkeys? -- come home to roost:

• Individual income tax rates go from 10, 15, 25, 28, 33 and 35 percent to 15, 28, 31, 36 and 39.6 percent.
  
• The child credit drops from $1,000 to $500 per child.
  
• Capital gains tax rates revert to 10 or 20 percent depending on the taxpayer's adjusted gross income.
  
• Dividends would again be taxed at the higher ordinary income rates noted above.
• After being fully phased out for tax year 2010, the estate tax returns with a top rate of 60 percent and a $1 million exemption.

If you plan on being around in the next five years, it's kind of scary, isn't it?

But I guess we, or our kids, and Congress, but not the members who set this all in motion, will just have to worry about that when the time comes.

Any guess on what lawmakers then will consider more important, crafting better overall tax policy or getting re-elected?