Fiscal Cliff Will Bring Taxing Situation

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by Jason McLure, December 2012   Dec 21, 2012

With the White House and Congress struggling to reach a deal to avoid the automatic tax hikes and spending cuts due to take effect in 2013, Tuck Professor of Accounting Richard Sansing looks at how going over the fiscal cliff would affect what you’ll pay the Internal Revenue Service next year. 

Q: Costco, Wal-Mart and Las Vegas Sands are among a number of large companies that have made special dividend payments to shareholders before the end of 2012. What’s going on?

Individual investors in the U.S. will face a 15 percent tax rate on dividends received in 2012. If we go over the so-called “fiscal cliff,” those rates would be over 40 percent for those in the highest income brackets. That’s because for much of our history, dividends were taxed at the same rate as other income. Early in the Bush Administration, the tax rate on dividends was cut to 15 percent. The argument was that since corporate profits are taxed, taxing dividends paid from those profits resulted in double-taxation. Most other countries do not tax distributed corporate profits so heavily. Unless Congress and the White House reach an agreement, dividends will be taxed at the same rate as the rest of your income. If you receive $100 in dividends today, you’ll get to keep $85 of that. As of Jan. 1, if you were among the highest income group, you’d keep less than $60, so there is a strong incentive for companies to pay their dividends now.

Q: If rates could rise so dramatically, why aren’t all companies doing this?

Some companies may have a better use for their cash, such as investing it in new equipment. Others keep a lot of their cash overseas. Apple, for instance, would like to pay this kind of dividend before year-end but its foreign operations would take a big tax hit. Suppose Apple’s profits in a country overseas are taxed at 16 percent. If it then repatriates some of those profits to the U.S., they have to pay additional tax to the U.S. government equivalent to the difference between their foreign profit tax rate of 16 percent and the U.S. rate of 35 percent. That means 19 percent of all the cash they’d move back to the U.S. to pay dividends would go to the U.S. government.

Q: What effect will a potential rise in the capital gains tax have? Will we see a lot of people selling shares before Jan. 1 to take gains at the lower rate?

If we go over the fiscal cliff, the capital gains rate will go from 15 to 20 percent. I don’t think this is great enough to induce any huge behavioral change. If you’re planning to liquidate your portfolio some time in the next year, you may move up the date to do it in 2012 rather than 2013, but I don’t expect to see a huge number of people doing this.

Q: What other tax impacts will we see on individuals?

Payroll taxes will also rise if there is no agreement. Let’s take a family of four making about $40,000 a year. They don’t pay any income tax, but they do pay payroll tax. If we go over the fiscal cliff, the payroll rate will rise from 4.2 percent to 6.2 percent. That works out to about $67 more per month. If you’re living paycheck to paycheck, cash is going to start running short a bit sooner.