A Word From The Advisor
Taxing Times

As the U.S. approaches one of the most momentous elections in its history, the parties offer voters a clear choice between two different approaches to tax policy and the appropriate economic role of government. John McCain adheres to the traditional Republican view that a lower tax burden on business and on individuals spurs economic growth. Barack Obama promotes the idea that government’s most appropriate role, indeed its duty, is to repair economic inequality, and that wealth redistribution through progressive taxation is an appropriate political goal.

The Bush administration tax cuts, enacted in 2001/2003, are due to automatically expire on December 31, 2010. This looming event, coupled with our mushrooming budget deficit, leads many to believe that federal taxes will rise no matter who is elected president. In the run-up to the November 4 election, special interests will surface and press their agendas. In the meanwhile, a nearly trillion-dollar rescue of the investment banking and the housing sector has been passed. Then, after the election, Congress will re-enter the fray, applying its own agenda to influence outcomes. The proposals described herein are therefore very much in flux, particularly in light of an added tax burden from the bailout of Wall Street. Candidates will need to adjust their plans to reflect realities as our economic situation evolves.

The two plans
According to Tax Policy Center, a non-partisan joint venture of the Urban Institute and the Brookings Institution, the two candidates’ tax policies break down as follows:

Senator McCain would:

• permanently extend the Bush tax cuts, including those for capital gains and dividends
• reduce the corporate income tax rate (now the second-highest in the world) and allow immediate deductions for investments in certain capital equipment
• replace the exclusion from income for employer-sponsored health insurance with refundable credit of $2,500/individuals and $5,000/families
• increase deductions for taxpayers supporting dependents
• lessen the bite on estate tax and AMT, more so than Senator Obama
• require a 3/5 majority in Congress to raise taxes

Senator Obama would:

• permanently extend certain provisions of the Bush tax cuts primarily affecting taxpayers with incomes under $250,000, and he would repeal the cuts in the top two marginal income tax rates
• increase the maximum rate on capital gains and raise the top tax rate on qualified dividends from its current level of 15% to levels taxed as high as ordinary income
• introduce income-related federal tax subsidies for health insurance
• enact new and expanded targeted tax breaks for workers, retirees, homeowners, savers, students, and new farmers
• lessen the bite on estate tax and AMT, but less so than Senator McCain
• eliminate income taxes on seniors making less than $50,000 a year

Proposed changes in federal income tax
Senator McCain’s plan would benefit Americans with very high incomes with almost all receiving tax cuts that would, on average, raise their after-tax incomes. Those in the top one percent, with annual incomes of at least $603,000, would enjoy an after-tax boost of 3.4%, or around $45,000. For middle-income taxpayers, McCain’s program would increase after-tax income an average of about 3%, or $1,400 annually, by 2012. On average, taxpayers would see their tax bill cut by nearly $1,200, which equates to an increase of 2% in after-tax income. Fewer households at the bottom of the income distribution would get tax cuts, and those tax cuts would be small as a share of after-tax income.

Senator Obama would raise taxes on the highest income earners. Those with at least $603,000 in annual income would see a dramatic decline in their after-tax income of 8.7% or $116,000. He would offer tax breaks to lower- and middle-income taxpayers. The largest tax cuts would go to those at the bottom of the income distribution, giving them the biggest after-tax income boost as a percentage of income – between 2.4% and 5.5%. On average, taxpayers would see their tax bill cut by $160, translating to an after-tax income boost of 0.3%.

Under Senator McCain’s proposed plan, the top marginal rates (35 percent on individual income and 25 percent on corporate income) would be lower than under Senator Obama’s plan (39.6 and 35 percent, respectively).

Under Obama’s plan, top earners would pay a marginal federal tax rate of approximately 46.5 percent (that includes the Medicare tax and Obama’s proposed hike in Social Security taxes); considerably higher than the 35 percent they would pay under McCain. When you factor in state income tax, this means that high earners will potentially be transferring more than 50% of their income in tax to our government.

Intergenerational wealth is targeted
Because the 2010 estate tax automatically reverts to a zero level in the last year of Bush’s 2001 tax cuts, federal estate tax on inherited wealth will be the first tax issue any new administration will grapple with in 2009. It’s just not tenable to have zero tax on estates in today’s budgetary environment. Therefore Congress will be forced to hash out an arrangement; we predict a compromise solution falling somewhere between the candidates’ estate tax proposals:

We anticipate a revised estate tax to fall somewhere in the 30-35% range, paid on estates above an exemption of $3.5 – $4 million. That represents a significant increase from the current level of 15% in 2008.

Current tax rate on dividends & capital gains is threatened
Taxation of dividends and capital gains is a controversial issue in public finance. Relatively high effective tax rates on capital income, particularly emanating from the corporate sector, can be a disincentive to investment and an impediment to economic growth; at worst, encouraging corporations to shift their business offshore. Corporations pay tax on profits before distributing dividends to shareholders. Shareholders then pay additional, individual-level tax on dividends received. Imposing two layers of taxation on corporate income can result in a substantially higher total tax rate on corporate income than the rate on other types of income. This thinking led policymakers in 2003 to reduce the tax rate on capital gains and dividend income to 15 percent. This relatively low tax rate on dividend income created strong demand for dividend-paying stocks and has been a boon for retirees who rely on this source of income.

The bottom line
Under a President McCain: Paired with a Democratic Congress, a President McCain may not be able to make tax cuts permanent. A corporate tax reduction can only be passed in a major reform bill, and, if so, perhaps to 32%. Look for a grand deal with tax increases and spending cuts in 2010 should the Democrats have significant majorities in a McCain term.

Under a President Obama: Early in an Obama administration, expect a major tax bill raising income, cap gains, dividend, “sin” and international taxes. It’s possible that proposed tax cuts may never be implemented. Cap gains and dividend tax will be higher than 20%. Congress wants tax rates higher, and Obama will adhere to his party after the election.

You and your portfolio
With Oakwood as your wealth manager, we will continue to provide a service in all economic environments, and will make appropriate adjustments as events unfold. It is paramount that we consider the implications of changes to your economic situation.

While the overarching goals of the Democrats may be greater income equality, the unintended consequences may hurt retirees who depend on after-tax dividend income. True, we have enjoyed a five-year tax bonanza but increasing tax on dividends, either through returning to the (Clinton era) 28% rate or by treating dividends as ordinary income, could cause a double whammy on retirees who depend on dividends for their retirement income.

• Let’s say a retiree owns $1M of dividend-paying stocks with a 5% dividend, that’s $50K pre-tax, and $42.5K after the 15% dividend tax, i.e. a 4.25% after-tax yield.
  
  
• Now, if the $50K of dividends is taxed at 39.6%, the after tax proceeds drop to $30.2K, for a yield of only 3.02%... it’s like a 29% pay cut to the retiree.
  
  
• Even worse, if the retiree sells his/her dividend-paying stocks, a buyer may be looking to recreate the original 4.25% after-tax yield. To achieve this with the new after-tax dividend payment of $30.2K, the price of the shares would necessarily fall to $710K, the same 29% decline.

With higher taxes likely, dividend-paying stocks may become less attractive.

On the capital gains front, our best advice to clients who are considering taking capital gains is to take them sooner rather than later to mitigate the likely risk of paying additional tax in the near future. In our tax-managed approach, we are very sensitive to the implications of short-term and long-term gains. Today there is a huge gap between the tax impact of a short term and a long-term gain. Capital gains may become more valuable than ordinary income in a world where the capital gains tax goes from 15 to 20% and the tax on dividends, if treated as ordinary income, goes up to 39.6%.

In the bond arena, an Obama environment will likely see muni bond yields fall and their prices rise, as more investors seek tax-free instruments to adjust their taxable income. In this same scenario, we would see taxable bond yields rise, and their prices fall. However, the whole arena is so complex that until we get the actual legislation, we cannot predict how it will work out.

Across industry sectors, we see several possible outcomes of the candidates’ differing economic/tax policies:

Action-oriented Congress on the way
Pay attention . . . because 2008’s biggest change may come not in the dramatic presidential race but in Congress. Whether McCain or Obama wins, there is a strong probability that Democrats will gain in congressional races, potentially adding enough seats to their current slim majority in the Senate to reach 57 votes, close to the 60 votes required or needed to push through bills and override a filibuster. Assuming the occasional moderate Republican crosses the aisle, this could break legislative gridlock. In the event of a Democratic president as well as a Democratic Congress, there is more likelihood for government legislation. A Republican president will have to reach out to work with an even larger Democratic majority and compromise to get things done.

Our nation’s economy is extremely fragile. We are very concerned about whether Americans can tolerate additional tax burdens when they are struggling to maintain their homes, jobs, and health insurance. The stock market tends to dislike uncertainty; and the election—with its potential for major policy changes—will weigh on the market. Taxes, and the prospect of tax increases on cap gains and dividends, are a huge area of uncertainty directly affecting investors.

No matter what the outcome, we remain deeply interested in your concerns about the potential changes to your financial situation. We strive, as always, to make decisions that are best for you. Contact us. We want to keep you involved. It’s not just about what is academically correct; it’s also about how you see your portfolio. We wrote this piece to share with you what we have monitored on the economic and political environment. We’ll be by your side through any changes. In the meantime, we hope you enjoy the robust debate and the broad-based engagement in the political process that we see and hear in the country today.