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With budget deficits mounting and continuing unabated into the future, government leaders agree that significant changes to the tax system are necessary if the U.S. wants to avoid becoming the next featured player in the global sovereign debt crisis. With a variety of proposals up for debate, you need to know what impact different tax reform measures would have on your personal finances and your investment portfolio.
The Fiscal Commission proposed many different measures in an effort to identify ways to increase government revenue and reduce spending. With no holds barred, many of the proposals were extremely controversial, ranging from lowering corporate taxes and ending popular tax deductions for mortgage interest and state and local taxes to moving up the retirement age for Social Security and cutting payments under Medicare.
It's unlikely that all of these will become law in their present form -- even the commission failed to reach the vote threshold necessary to send its plan to Congress. But considering the impact of each measure will help you anticipate the effect they would have on your finances even in watered-down form. So let's attack them one by one.
Lower corporate taxes
The Fiscal Commission recommended reducing the corporate tax rate from its current level of 35%. Clearly, that would have a big impact on companies that pay large amounts of tax. According to figures compiled by economist Martin Sullivan for testimony before Congress, drugstore company CVS Caremark (NYSE: CVS ) pays an effective rate of tax of nearly 39%, with several major retailers and health-care insurance companies paying similarly high rates.
But many companies pay next to nothing in tax already. Range Resources (NYSE: RRC ) paid less than 1% of its pre-tax income in taxes from 2005 to 2009, based on figures from Capital IQ. Western Digital (NYSE: WDC ) and Broadcom (Nasdaq: BRCM ) paid around 2% and 3%, respectively. So investors expecting to see big gains for their stocks from a corporate tax cut need to look more closely at their companies to see if they're actually even paying much tax to begin with.
Personal income tax reform
The Fiscal Commission proposals recommend big changes to the personal income tax system. It would lower rates but remove many current deductions, replacing mortgage interest and charitable contribution deductions with a smaller 12% tax credit. Dividend tax rates would return to the same rates as ordinary income.
From a personal standpoint, these changes would discourage home ownership, especially among higher-income taxpayers, as well as potentially reduce charitable giving. Depending on how much marginal rates were lowered -- one proposal suggested three tiers ranging from 15% to 35%, which wouldn't really be a reduction from current levels -- a rise in the effective rate on dividends could reverse the trend toward high-dividend stocks, or it could encourage more participation in tax-favored accounts in which dividend taxation would be irrelevant.
From an investing standpoint, a further reduction in demand for homes would hurt homebuilders, especially Toll Brothers (NYSE: TOL ) which bills itself as a luxury homebuilder aimed at the high-income taxpayers most affected by loss of the mortgage interest deduction. But apartment REITs Equity Residential (NYSE: EQR ) and AvalonBay Communities (NYSE: AVB ) have already been benefiting from the adverse environment for homeowners and could see even bigger benefits going forward if tax laws discourage homebuying.
Along with tax-based revenue measures, the Fiscal Commission recommended changes to entitlement programs. For Social Security, gradually raising the early retirement age from 62 to 64 and the full retirement age from 67 to 69 would help the program survive longer, but at the cost of forcing younger Americans to work longer or plan for a longer period of retirement without financial assistance. For Medicare, higher out-of-pocket payments and proposals to limit payments for prescription drugs would hurt both seniors who already struggle to make ends meet as well as pharmaceutical companies that rely on sales to seniors for their profits.
In addition, the commission recommended long-feared cuts to defense spending and the discretionary spending areas of the federal budget. That would potentially hurt defense contractors and other companies that rely on government contracts, although those stocks have largely anticipated these cuts with depressed share prices.
It's going to take a lot of political will to implement wide-ranging changes like these, and skeptics might argue that it will never happen. But most people agree that we need to take action to balance the federal budget, and eventually, some combination of proposals like these will be necessary. If you're prepared in advance, you'll be able to make the most of the changes when they happen.
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