The Looming Triple Tax Increase in Your Future: Merrill Matthews, Institute for Policy Innovation

Note: I read an editorial by Merrill Matthews and emailed him toote suite: how is the 3.8% Medicare tax going to affect real estate here in Dallas, I asked? The resident scholar with the Institute for Policy Innovation, public policy analyst specializing in health care issues,  author of numerous studies in health policy and past president of the Health Economics Roundtable for the National Association for Business Economics, the largest trade association of business economists, was gracious enough to indulge me: 

We are moving closer to that “fiscal cliff,” and it will hit investors harder than most. If President Barack Obama gets his way, one very important tax rate will triple—literally, overnight.

The so-called Bush tax cuts are set to expire at the end of the year.  That means that unless Congress acts, all of the current income tax rates will rise to pre-2001 levels immediately.

Most of the attention has been on the income tax rate.  Those in the highest tax bracket will see their rate rise from 35% to 39.6%.

But the Bush tax cuts dropped the rate on dividends, which were taxed at the personal income level, to 15% regardless of income.  If the Bush tax cuts expire, the dividend tax for high-income workers will return to 39.6%.

But there’s more.  The health care law imposes for the first time ever a 3.8% Medicare tax on passive income, including dividends and interest.  So the effective dividend tax rate for those at the upper end of the income scale will nearly triple, to 43.4%.

That potential increase is affecting investment decisions now.  Several companies have announced that they will be paying dividends early, before the end of the year, in order to avoid the tax increase—if it comes.

Some investors are divesting of other assets.  A friend just sold a $1.2 million second home he owned in Colorado.  He’s convinced that if we go off the cliff, the economy will tank, bringing on a double-dip recession, and he would either lose money or be unable to sell the place.  He wanted to get out while the getting’s good.

The President’s plan couldn’t be timed any worse.  Dividend-paying stocks have been one of the bright spots for investors.  That’s in part because interest rates have been kept so (artificially) low by the Federal Reserve Bank.  Investors are understandably looking for better returns.

Higher dividend taxes will make stocks that pay dividends less attractive to investors.  So those who currently hold dividend-paying stocks—everyone from middle-class folks with 401(k)s to union pension funds to non-profit foundations—would see the value of their investments decline substantially.

Further, higher dividend taxes will likely cause companies to cut dividends in favor of deploying their cash in other ways, like re-purchasing their own stock.  So individuals counting on their share of a company’s profits for their income—which they’d normally receive via a cash dividend—could find themselves out of luck.

That will be particularly bad news for retirees, many of whom depend on dividends as a staple of their fixed incomes.  According to the IRS, more than half of dividend payments go to Americans over age 65—and almost 75% go to those over age 55.

Another bright spot for investors over the past few years has been Real Estate Investment Trust (REIT) mutual funds.  Money has poured into that sector, especially after the official end of the recession in June 2009.  People were putting money there in the hope of reaping strong capital gains.  But there’s a problem there, too.

The capital gains tax will also increase, from 15% to 20%.  Plus, we have to add the 3.8% Medicare tax for the first time ever, for an increase to 23.8%.  To be sure, not nearly as high as the dividends tax, but a significant increase nonetheless.

President Obama needs to understand that not all tax increases and tax cuts are created equally; some will have very little economic impact, others will have a significant impact.  While the income tax rate increases are important, and detrimental, they pale in comparison to the economic damage from dividends and capital gains tax increases.

A dividends tax hike could greatly dampen investment, which would bring a hammer down on a weak economy.  Investors would close their wallets, and the real estate market would be one of the first to feel it.  With housing prices finally moving up in most places, especially in Dallas Fort Worth, the negative impact of a tripling of the dividends tax would surely reverse those gains.

Merrill Matthews is a resident scholar with the Institute for Policy Innovation in Dallas, Texas.