Democrats and Republicans are headed for a big blowup over taxes — and the treatment of capital gains could be what sets them off.
Sparks could fly over the capital gains tax when Congress tackles broad reform, lawmakers indicated today at a hearing before going on recess until after the elections.
A twin goal for many lawmakers is to expand the tax base and lower rates across the board. Tension will center on whether raising taxes on capital gains is necessary to pay for tax cuts elsewhere.
Most investment advisers want the capital gains rate to stay at 15%.
But a veteran of the last major tax reform in 1986 argued that the tax rate on investment gains must rise to a rate at or near the top individual rate, if that level is lowered to 30% or less.
David Brockway, a partner at Bingham McCutchen LLP, said that boosting the capital gains rate was the linchpin of tax overhaul when he was chief of staff of the Joint Committee on Taxation and in the middle of the negotiations.
“I tend to view capital gains as a gateway issue,” he told a joint hearing of the House Ways & Means and Senate Finance committees on Thursday. “In my view, that was the key to the entire process [in 1986].”
It isn't politically realistic to lower rates for all income levels without also boosting them on investments, Mr. Brockway said.
Without that step, Congress would have to take large whacks at tax benefits enjoyed by the middle class.
“I just don't think the math works,” Mr. Brockway said in an interview. “This is the hard reality of comprehensive tax reform.”
A key Democrat embraced Mr. Brockway's message.
“This has been a sobering hearing,” said Rep. Sander Levin, D-Mich., ranking member of the House Ways & Means Committee. “We need to have much less talk about [rate] targets and more about tradeoffs.”
But Mr. Levin's counterpart on the panel dismissed the notion.
“I don't agree with that,” Rep. Dave Camp, R-Mich., chairman of the House Ways & Means Committee told reporters after the hearing. “I don't think there are any binary choices in tax reform.”
The hearing highlighted differing attitudes toward capital gains taxation. The GOP promotes low rates to spur investment and growth while Democrats put the debate in the context of tax code progressivity.
“Low capital gains tax rates are the main reason why many wealthy individuals pay lower tax rates than middle class families,” said Montana Sen. Max Baucus, chairman of the Senate Finance Committee.
If Congress fails to extend the Bush tax cuts by Dec. 31, the capital gains rate will rise to 20%. The effective rate will be higher when a 3.8% Medicare tax on investment income goes into effect on Jan. 1.
William Stanfill, a general partner at the Montegra Capital Income Fund, is sanguine about an investment taxation hike. He maintains that market fundamentals, rather than the tax code, should determine where money flows.
“The sky will not fall if the capital gains rate goes up,” Mr. Stanfill said at today's hearing. “Tell me what the rate will be. Make sure it is fair, and we'll work within the guidelines.”
To be sure, he's an outlier among advisers on capital gains.
Kenneth Klabunde, vice president of City Securities Corp., wants Congress to stand pat on investment tax rates because the United States is already near the top of the global rankings in the taxes on capital.
“They've got to stay where they are or come down,” Mr. Klabunde said. “I'm worried about our competitiveness as a nation. The last thing we need to do is provide a disincentive for capital investment in American corporations.”
Mr. Klabunde's argument echoed that of many Republicans. Mr. Camp asserted that the capital gains tax can sometimes be a “double layer of taxation” on top of corporate rates. He said the “total integrated rate” is nearly 45%.
Another adviser is hoping that Congress does not touch – or only slightly moves – the capital gains rate.
“For my clients, I'd like to see it stay where it is,” said David O'Brien, president of O'Brien Financial Planning Inc. “But pragmatically, 20%. It's not expected by anybody that the rates won't go up. Now the question is: How high?”
Congress likely will have to consider tax revenue as well as spending cuts next year as it attempts to reduce the deficit and undertake tax reform. One adviser warns that capital gains are already slated to increase, even if Congress does not fall off the fiscal cliff.
“I would like [the rate] to stay where it is, given the Medicare surtax that is definitely coming in January,” said Erin Baehr, president of Baehr Family Financial LLC.
She pointed out that many elderly Americans depend on investment income to supplement their retirement nest eggs.
A capital gains increase, especially if it's coupled with a hike to the current 15% dividend rate, “would add stress on what is already a low income,” Ms. Baehr said.
Congress will have to weigh those worries in 2013.
“As we work on comprehensive tax reform, the treatment of capital gains is one of the most difficult issues we face,” Mr. Baucus said.
