No one's happy about the pace at which lawmakers are acting to resolve what's quickly becoming a debt ceiling crisis. But the longer-term issue goes well beyond the Aug. 2 deadline. The changes in tax policy that could result from debt ceiling negotiations could not only greatly affect your taxes, but also have a major impact on many companies as well.
Saying goodbye to big deductions
One of the biggest stumbling blocks in the debate centers on tax rates. Although both sides differ on how much they want deficit-cutting moves to come from higher revenue, no one wants to take responsibility for increasing the marginal tax rates from their current levels.
As a result, those who want to increase revenue are looking instead at what's known as "tax expenditures." These include deductions that the tax law allows taxpayers to take against income tax. By removing these tax expenditures, one could argue that the government is cutting spending.
Semantic niceties aside, though, getting rid of tax expenditures could actually mean a big hike on your tax bill in coming years. You've probably taken advantage of many of the deductions on the tax expenditure list for years. If they disappear, and the government doesn't lower its overall tax rates to compensate, you can expect your final taxable income to rise. Your refund could easily shrink or even disappear as a result.
The biggest tax expenditures
What big tax provisions could be headed for the chopping block? Here are some of the most popular ones on the endangered list right now:
- If your employer pays for all or part of your health insurance at work, you don't have to pay tax on its value, while the company gets a tax deduction. That costs the government $659 billion annually.
- Homeowners can write off the interest they pay on their mortgages, which cuts taxes by $484 billion each year.
- The preferential 15% rate on capital gains and dividends adds up to $403 billion annually in lost taxes.
- The remainder of the top 10 includes equally important deductions for many, including donations to charity, pension and 401(k) contributions, and portions of Social Security benefits.
Certainly, losing these provisions would lead to a higher tax bill for many Americans. But it could cause pain for many U.S. companies as well.
The big losers from tax reform
The top tax expenditure on the list, health insurance, affects any employer that includes coverage as a benefit. If the government eliminates the deduction for companies, it would have a direct impact on corporate taxes, while simply forcing employees to include benefits in income could lead to employers having to pay more to make up for higher taxes. With Wal-Mart (NYSE: WMT), McDonald's (NYSE: MCD), and United Parcel Service (NYSE: UPS) among the top employers in the nation, they would arguably have the most to lose.
Policymakers have thrown around the idea of cutting mortgage interest as a deduction for a while. On one hand, many taxpayers get only minimal tax advantages from mortgage interest, because they don't have enough deductions to benefit from itemizing over taking a standard deduction. And while many fear that a drop in homebuying demand would deal stressed homebuilders Beazer Homes (NYSE: BZH) and Hovnanian (NYSE: HOV) a death blow, fellow Fool Morgan Housel argues the "correlation between mortgage interest deductions and homeownership rates seems elusive." Moreover, with many homeowners paying down mortgage debt, the deduction is increasingly becoming a secondary consideration to improving personal balance sheets.
Finally, eliminating low dividend and capital gains rates would represent yet another hit on savers, who've already had to flee safer investments like bonds and cash due to low interest rates. Some high-yielding dividend payers, including Annaly Capital (NYSE: NLY) and American Capital Agency (Nasdaq: AGNC), wouldn't see any reduction in shareholder interest because their payouts already fail to qualify for lower rates. But for run-of-the-mill dividend stocks, some investors could choose to shift their strategy away from dividend stocks to minimize taxes.
Don't panic
It's entirely possible that the government will finally resolve its internal dispute in the next week, before the Aug. 2 deadline for default. But the decision it makes will likely have long-term ramifications for years to come, and you should invest accordingly.
Depending on your tax bracket, dividend stocks would remain attractive even if their tax benefits get watered down. To get 13 strong ideas for your consideration, take advantage of this offer to have the Fool's free special report on dividend stocks sent to you with no further obligation.
