US Tax Policy Bad for the Long-Term : Part 1

I start by calling this "Part 1", because there are so many issues with the current US tax policy with regards to the long-term health of this country, I will undoubtedly be writing many a subsequent article about this mess.

I begin by discussing a topic closely related to prior blog entries (about the falling dollar, lack of savings, and the likes) - in particular, how current US income-tax policy encourages the average person to not save.

Whereas recent tax law changes give favorable income-tax rates to earnings from capital gains and dividends (which disproportionately benefits the wealty), earnings that the "average" person makes from their investment activities are more likely to be taxed at normal income tax rates. The current maximum tax-rate on long-term capital gains and dividends is only 15%. What is the normal income-tax rate compared to this 15% maximum? The 2006 tax-rate table below is provided courtesy of: http://www.irs.gov/formspubs/article/0,,id=150856,00.html

(2006 Rates for Married, filing jointly - other tables are available via URL above)

Taxable income >	And, <	The tax is:
$0	$15,100	10% of the amount over $0
$15,100	$61,300	$1,510.00 plus 15% of the amount over 15,100
$61,300	$123,700	$8,440.00 plus 25% of the amount over 61,300
$123,700	$188,450	$24,040.00 plus 28% of the amount over 123,700
$188,450	$336,550	$42,170.00 plus 33% of the amount over 188,450
$336,550	no limit	$91,043.00 plus 35% of the amount over 336,550

As you can see, if you are married and make over $61,300, or single and make over $30,650 in taxable income (i.e., you are squarely in the so called "middle-class" realm), you will be paying 25% or more in taxes on your any investment income that is taxed at normal income-tax rates.

Now, consider the following "investment options" that the average person may have:

1. Savings Accounts, Money Markets, and other similar cash-accounts: any interest earned is taxed at full income-tax rates;
2. Savings Bonds (also Treasury Bills, Bonds, etc): any interest earned is taxed at full income-tax rates, though at least the interest is free of State taxes;
3. CD's (Certificates of Deposit): you guessed it, earnings are taxed at full income-tax rates;
4. 401K retirement accounts: though a more thorough discussion is needed, the bottom line is that all those earnings you see on your 401K account statement are, for the most part, capital gains and dividends your investments have earned. But, when you go to withdraw funds from your 401K in the future, those earnings are taxed at full income-tax rates (sorry, the government isn't giving you a capital gains and dividends reduction on earnings in that 401K; presumably, this is because you had the benefit of investing pre-tax dollars into the 401K fund to begin with - though you had that same benefit before taxes were cut on capital gains and dividends).
   

So, why do we not encourage savings in this country by extending the 15%-maximum-tax-rate to these investment earnings the average person has? Since our national savings rate is zero, how much could this possibly cost the government in lost tax-revenue? And, a common argument for tax-relief on dividends and capital gains is to encourage business investment and growth. Well, any extra dollars sitting in savings accounts or other investments still encourage investment and growth, since banks make loans against deposits, and the government funds it debt with bonds (and, US citizen purchases of bonds reduces our dependence on foreign buyers, and reduces current account deficits with foreign countries, which ultimately helps our ability to grow and prosper).

The argument can be made that your funds are not "at risk" as they are when invested in equities. That may be, but historical rates of returns are also lower on fixed-income funds vs. equities as well. I personally believe that funds are still "at risk", though at a significantly lower level. When you place your money into CDs or Bonds, you are taking a risk that interest rates will not rise substantially during the time you hold these investments - since, if they do, you suffer the opportunity cost of not being able to realize those new, higher rates. As for short-term interest (on money markets, checking, savings accounts), you may not have nearly as much risk, but once again you are probably not realizing as high of rate as you would if you locked up your money for a longer term, thus you risk not getting the maximum amount you can on your funds. Bottom line: there is always some risk, and since the reward possibilities are tied to the risk level, why not give all these investment vehicles the same tax-preferred-earnings status of a maximum 15% rate? It would go a long way to encourage the masses to save; and if it didn't, what is lost - nothing, since we save zero currently!

For the long-term health of this country, we must encourage and promote savings so we can invest in ourselves in the years ahead when capital from abroad may become less free-flowing.