WASHINGTON -- For those in the business of providing investment advice, the situation in the nation's capital is getting serious.
With Washington gridlocked and steeped in uncertainty over a series of tax cuts set to expire at the end of the year, members of the Senate Finance Committee and House Ways and Means Committee met for a joint session to consider a critical and contentious facet of the tax code: capital gains.
"As we work on comprehensive tax reform, treatment of capital gains is one of the most difficult issues we face," said Sen. Max Baucus (D-Mont.), chairman of the Finance Committee. "Some are pessimistic and don't believe we can agree. I am optimistic. We need to come together and find a workable solution."
If Congress is unable to reach an agreement on taxes, the current rates that were set in the Bush administration and renewed in 2010 will expire. That would mean that capital gains would spike from the current maximum rate of 15% to 25%, including a measure in the health care reform law that increases investment-income rates for top earners and an expiring provision concerning itemized deductions.
Tax Policy Center explanation: http://taxvox.taxpolicycenter.org/2012/01/24/capital-gains-taxes-are-going-up/
Capital gains are one of a broader set of taxes that stand to increase in January, along with the rates on ordinary income, dividends, estates and payrolls. Economists generally agree that the across-the-board tax increases, when combined with a looming set of automatic cuts in federal spending that would take effect if Congress can't strike a deal on debt and the deficit, would send the economy tumbling back into recession, or over the fiscal cliff, as it has come to be known.
Allen Sinai, chief global economist and strategist with Decision Economics, has projected that the S&P 500 Price Index will see an average decline of 16.2% from 2013 through 2017 if all the tax cuts are repealed. Almost all of that depreciation would be attributed to allowing the cuts on capital gains and dividend income lapse, according to Sinai's model.
Members of both parties, in Washington and on the campaign trail, have spoken with rising urgency about the need to avert the fiscal cliff, though deep fissures about the appropriate tax-rate levels remain. President Obama has proposed extending the tax cuts for all but the top earning Americans, while Republicans have argued for a wholesale extension.
If lawmakers are to strike a deal ahead of the year-end deadline, it will come in the lame-duck session, as this is the last working week until the November election.
At Thursday's hearing, lawmakers on both sides of the aisle expressed support for a comprehensive overhaul and simplification of the tax code, a complex initiative that will involve a pointed debate over whether to bring capital gains rates into closer alignment with ordinary income taxes, as the 1986 Tax Reform Act did, or to preserve the comparatively lower rates of recent years.
David Brockway, currently a partner at the law firm Bingham McCutchen LLP who served as chief of staff on the Joint Committee on Taxation while the 1986 bill was making its way through Congress, expressed strong support for a comprehensive tax reform effort, but suggested that members would only achieve sufficient bipartisan support to advance legislation if capital gains rates were raised. He explained that in the drafting of the Tax Reform Act, increasing rates on capital gains was not a "design objective," but that in running the numbers staffers determined that that it was the least onerous path to meet their revenue and distribution goals.
"It was simply the only way the legislation would move forward under the constraints they were operating [under]," Brockway told the panel.
Other witnesses warned that any moves to increase capital gains rates would invite a host of unintended consequences, with investors responding by shifting capital into other assets or sitting on their holdings to avoid paying the tax, a phenomenon known as the lock-in effect.
Lawrence Lindsey, president and CEO of the Lindsey Group, warned of the macroeconomic dip that an increase in capital gains could cost, citing Sinai's economic model and urging lawmakers to hold the current rates in place.
"Given the hole that we're in," Lindsey said, "I think our whole focus should be on making America the best place in the world in which to invest, to start a business and create jobs. It's as simple as that."
Other industry stakeholders have raised similar concerns about the effect on certain stocks if the tax rates on dividend income are allowed to rise. One study commissioned by a group representing utility companies cautioned that a rise in the rates of dividend income would drive down the payouts to investors and sap stock prices.
Lawmakers heard conflicting messages on the impact of a potential increase in capital gains rates at Wednesday's hearing. Angel investor David Verrill, the managing director of the Hub Angels Investment Group and Chairman of the Angel Capital Association, warned that if rates were allowed to jump past 15%, fewer investors would be willing to provide seed money to early-stage companies.
"If angel investors are taxed more they will have less to invest," Verrill told the panel, arguing that the long-term success of the companies that those investors back would translate into tax revenue for the federal government sufficient to keep capital gains rates low.
But those dire predictions overstate the impact of a capital gains hike, according to William Stanfill, a general partner at the Montegra Capital Income Fund and a veteran of the financial industry of more than four decades.
"The sky will not fall if capital gains go up," Stanfill said, describing how the rate has fluctuated between 15% and 28% over his career. "The capital gains rate has had little impact on our investment planning, our ability to attract investors, or the financial results of those investments."