39.6% tax on dividends? It's looking more and more likely

President Barack Obama, offering a consolation prize to high-income Americans whose taxes he wants to raise next year, is proposing to scale back a scheduled tax increase on their dividends. A budget law Obama signed this year may keep the Democratic president from meeting that goal. A cut in the dividends rate to its current 15 percent, from rates as high as 39.6 percent, was among tax measures enacted under Republican President George W. Bush. All those cuts are scheduled to expire Dec. 31, and unless Congress acts, the previous higher rates would return next year. While Obama's proposed 20 percent dividend rate is an increase from this year's levy, it qualifies as a tax cut because it's less than the rate scheduled to take effect for 2011. Under the budget rules, any tax cuts benefitting individuals earning more than $200,000, or couples earning more than $250,000, must be offset with new tax revenue or spending cuts elsewhere. Passing Obama's plan under the so-called paygo rules would require lawmakers to find a combination of revenue and spending cuts of about $100 billion over 10 years. This would be difficult to achieve in an election year, tax experts said. The alternative -- finding the 60 senators required to vote for waiving the budget rule -- would be equally challenging in the 100-seat chamber, they said. ‘Virtually Impossible' Paygo “could make it virtually impossible” to cap the dividend rate at 20 percent, said John “Buck” Chapoton, a former top tax official in President Ronald Reagan's administration who is now a partner in Washington at Brown Investment Advisory & Trust and supports the lower dividend rate. The budget-balancing law, he said, “just makes Congress dysfunctional in a lot of ways.” The same conundrum doesn't apply to Obama's proposal on capital-gains rates, which would also increase to 20 percent from 15 percent for high incomes. That measure wouldn't have to be offset by new revenue or tax increases because 20 percent is the rate that prevailed before the Bush-era tax cuts were enacted. The paygo rules were first enacted under President George H.W. Bush in 1990 to require Congress to rein in deficit spending. The rules expired in 2002, months before Congress set the lower rates for dividends and capital gains that expire this year. Scaled-Back Legislation Paygo was reinstated in February, and has delayed or caused Democrats to scale back legislation extending jobless benefits for the long-term unemployed, help states provide health insurance to the poor, and provide pay increases to doctors participating in Medicare. They've also impeded renewal of about 75 expired tax breaks known as the “extenders” that include a research credit for businesses and personal deductions for state and local sales taxes paid. Congress has begun deliberation on extending $4 trillion in expiring Bush-era tax cuts under the shadow of a U.S. deficit forecast by the White House budget office to be a record $1.47 trillion for 2010 and $1.42 trillion for fiscal 2011, which starts Oct. 1. Paygo allows specific pieces of the 2001 and 2003 tax cuts totaling about $3 trillion to be financed with deficits. They include sustaining the lower 10 percent, 25 percent and 28 percent income-tax brackets; relief from the so-called marriage penalty that used to tax couples more than if they were two single; the $1,000 per child tax credit; and subsidies for day care, college tuition, and adoption. Alternative Minimum Tax The law also doesn't require offsets for the next two years to prevent the alternative minimum tax from subjecting 30 million households to $65 billion in additional taxes. And it would allow the top estate tax rate to be set at 45 percent in 2011 only. The estate tax is repealed for 2010 alone, though it would return with 55 percent rate if Congress doesn't act. Republicans and Democrats agree on the need to extend the vast majority of the Bush-era cuts. The biggest area of contention is over the $700 billion of higher taxes that would be paid by 3 percent of tax filers who earn more than $200,000, if Congress lets their Bush tax cuts expire. Lost revenue from extending those tax reductions would have to be paid for unless budget rules are waived. Republicans want the cuts extended along with rates for lower incomes and have indicated they may block the entire package if it doesn't include the high-income measures. Top Rates In addition to higher rates for capital gains and dividends, under Obama' plan the top marginal income-tax rates would increase to 36 percent and 39.6 percent from 33 percent and 35 percent now. Proposals to limit the estate tax on large estates would also need to be paid for. For Republicans to obtain the 60 Senate votes required to waive the rules, they would need the support of at least 20 Democrats. Democrats control 59 seats and Republicans have 41. So far, Republicans have the support of four Democrats and Joseph I. Lieberman, a Connecticut independent who usually votes with Democrats. One Republican, Senator George Voinovich of Ohio, has said he won't vote to extend any tax cuts that aren't paid for. Mark Bloomfield, president of the American Council for Capital Formation, a Washington group that advocates lower taxes on investments, said he expects lawmakers to ultimately waive the rules. “Paygo is paygo, but it's got termites in it,” he said.