As the investment community applauds the two-year extension of the 15% Federal tax rate on dividends and capital gains through 2010, which President Bush signed into law via the Tax Relief Extension Act of 2005 last Wednesday, Washington-watchers say it might be a while before investors can expect any further tax breaks.

And that means the progress on tax bills tailored to the mutual fund industry, such as the Generating Retirement Ownership Through Long-Term Holding (GROWTH) Act, might be stunted.

That bill, known inside the Beltway as HR 2121, would call for all taxes on mutual fund earnings to be deferred until a shareholder cashes out. Any dividends that are reinvested would likewise be tax deferrered according to the proposed bill, introduced by U.S. Representatives Paul Ryan (R-Wisc.) and William Jefferson (D-La.) last May.

The Investment Company Institute has championed the bill since its introduction, but also conceded it might be a two-year work in progress.

Others say it might be longer.

"The entire industry would clearly love to see the GROWTH Act pass," said Geoff Bobroff, president of Bobroff Consulting in East Greenwich, R.I. "But [it] is troubled because it tends to focus on one industry, and most tax legislation does not benefit a single provider. I think it's the right answer [for investors], but I don't know what the impetus would be to get Congress to support it."

One reason is that 60% of the 91 million Americans who invest in mutual funds do so through tax-sheltered accounts, such as 401(k) plans, and therefore are not affected by taxes on dividends and mutual funds - at least not now.

Another reason is the increasing Federal deficit, which is now estimated to be $371 billion, or $2,700 per tax return, according to the Washington-based Tax Foundation, a non-partisan research group.

"There's a great pressure in all of these tax bills to create an off-setting revenue source," said Neils Holch, executive director for the Coalition of Mutual Fund Investors, also based in Washington. "I think the focus right now is on extending current provisions on things slated to expire. I don't know if there's much money in the budget to do anything much more than that," Holch said.

But that doesn't mean that the recent extension is the end of investor-friendly tax-cuts forever.

In fact, if there is a lesson to be learned from the recent extension of the law capping taxes on capital gains and dividends, it's that politicians are increasingly aware of a relatively new electorate: the individual investor.

"Things like this that might not have passed 10 or 15 years ago are able to pass now," Holch said. A big part of the credit for this increased power goes to mutual funds. Whereas, in the past, investing in stocks and bonds was only for the wealthy, mutual funds and 401(k) plans gave the middle class access to well-respected money managers, new capital markets and a reason to think of themselves not just as income-earners, but as investors, Holch said.

And, as the recent extensions show, politicians know that once a tax break hits the books - even one written as a temporary reduction with a so-called sunset date - it's awfully hard to take it back.

However, it's also hard to justify new breaks when there's no easy way to make up the lost revenue, said Merideth Dodson, director of domestic campaigns for RESULTS, the Washington-based not-for-profit aimed toward ending hunger. In fact, Dodson argued, cuts like these don't lift the economy, but widen the gap between rich and poor.

"To have a 15% rate on taxation on what I consider unearned income when a teacher is paying a higher rate on earned income just to make ends meet is just not right," Dodson said.

But such an "us-against-them" mentality poses no serious political threat to the passage of the GROWTH Act, according to Max B. Sawicky, an economist with the Economic Policy Institute, a not-for-profit, non-partisan policy think tank.

"People are not so concerned when [other] people get a tax cut. They think it's a freebie, and there's not much outrage," Sawicky said. "The GROWTH Act will pass."

Opponents of the recent extension, and other tax cuts that target investors, say that such breaks only amplify the Federal deficit, and result in service cuts for those who need them.

"Every dollar of spending claims a tax dollar sooner or later, whether it's another [type of] tax or [to pay for] debt services. When you cut taxes without cutting spending, you're not cutting taxes broadly, you're shifting taxes to younger people," Sawicky said.

"So far, politicians have had a free ride with these tax cuts, because foreigners have been willing to lend us money. When they become more reluctant to buy more securities, that's when all the chickens will come home to roost in the U.S.," he continued.

And that's what politicians must think about before approving more cuts.

"Looking down the road, we're going to have to close the gap. With double-digit growth in healthcare costs, it's hard to tell someone they can't have a healthcare benefit, new treatment or drug because now we can't afford it, which is just another way of saying, We don't want to raise taxes to pay for it,'" Sawicky said. "I don't envy any politician caught between those imperatives."

Proponents of investor tax relief packages say that the $49.4 billion New York-based Standard & Poor's estimates investors will save in dividends and capital gains taxes through the two-year extension, for example, pumps more money into the economy, and speeds recovery. Companies begin hiring, people increase spending, and the government, which as an institution is itself a major investor, also benefits.

It's important to keep this momentum going, said Tom Roseen, a senior analyst with Lipper of New York. Even with the cuts, mutual fund investors alone paid $15.2 billion on their gains to Uncle Sam last year, compared to $9.6 billion in 2004, Roseen said. And while that's a sign of sound market growth, if the tax rate were to revert to pre-2003 levels, investors would have less to spend, and may even pull back from the market, he said.

Furthermore, until last year, some investors were still offsetting their losses from the 2000-2002 bear market against their gains.

"As larger dividends are going out, some people might get a little bit of sticker shock when they open their 1099 [tax forms] next year," Roseen said.

If the laws hadn't been extended until 2010, it would be even worse.

While people like Dodson and Sawicky argue that such tax cuts only benefit the wealthy, Roseen argues that when it comes to investing, mutual funds are really a middle-class tool. "I don't think a lot of multi-millionaires are in mutual funds," he said. "They are more likely to be into managed accounts and other, more sophisticated tools."

"It's true that ownership is dispersed very widely, but it's also true that the size of the savings is based on the size of people's portfolios, and this tax cut is very concentrated," Sawicky said.

In fact, Dodson estimated that while the average savings to an investor whose income was $70,000 per year was $30, a millionaire would get a break of nearly $42,000.

Still, Roseen maintains that any money investors get to keep in their pockets - or, better, in their retirement or savings accounts - is good for the individual, and for the economy overall. He cites the bump in market performance since the 2003 cuts were first enacted. Sawicky, however, is less convinced that the cuts passed in 2003 were the cause of the market upwing.

"The last couple of years have been good," Sawicky conceded. But, to date, the recovery since the 2000-2002 bear market hasn't been as good as others, such as that of the mid-1990s, a time when taxes went up. "Economists like to look at the whole cycle and compare it to something you can standardize against," he said. "By that criterion, this has been a pretty crappy recovery."

But there is a chance the recovery has just begun, and, if anything, keeping taxes low for investors will accelerate it or keep it from flattening, Roseen said. "[While] we were lucky to get two years' extension, I'd love to see this become a permanent part of tax law."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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