Canada: Obama’s 2015 Budget – The Definition Of DOA

Last Updated: January 29 2015
Article by Kevyn Nightingale

Now that the midterm elections – the last in which Barack Obama will be a participant – are in the past, the President has, in many respects, a free hand. He can show America what he's really about, with no possibility of redress. He is constitutionally barred from running in the next election.

He certainly has shown his hand. He wants to raise tax rates quite substantially for the richest of Americans, largely to finance more spending on the middle class. A cynic would argue that the more that gets spent on the middle class, the better for those who believe in bigger government. And President Obama is clearly a supporter of more government.

The middle class is overwhelmingly the biggest part of the electorate (depending on the definition, half to three-quarters of the population). Moving their mindset from an entrepreneurial one to a client-recipient one favors the long term growth of government.

Tax increase proposals

In the upcoming State of the Union address, Obama will ask Congress to:

  • Raise the top capital gain and dividend rates from 20% to 28% for those with income over US$500,000 per year
  • Impose a 'size' fee, impacting approximately 100 large financial institutions
  • On inherited assets, tax the capital gain that arose prior to the death of the individual who passed them on.

Pre-death gains to be taxed

This last change warrants some discussion. The U.S. system is different than Canada's. In Canada, the system is designed to tax the increase in value of assets at the time of death. If a person owns assets at that time, he is treated as having sold it to himself for the fair market value immediately before death. This is called a "deemed disposition". The taxable gain or income is included in his income for that year. This way, there's no fundamental tax difference between selling the asset before death and owning it at death. This rule applies regardless of one's wealth. Instead, the tax rate is based on one's income (including this gain) and goes up to about 25%, depending on the province of the decedent's residency.

The U.S. doesn't do it this way. Instead, it has an estate tax. When a wealthy person dies, the value of the asset is subject to a 40% tax. When someone who is not wealthy dies, there is no estate tax. For 2015, the line between these two states is a net worth of $5.43M – this amount is exempt from the tax.

As one can easily see, for high net worth individuals, 25% of the gain is much less than 40% of the value. So it's not like wealthy Americans are getting off scot-free. But Obama thinks that's not enough. He would like to capture the income tax piece as well.

In both cases, the beneficiary starts with an inherited asset having a tax cost equal to the fair market at the previous owner's death. When the beneficiary sells the asset, he pays tax only on the increase in value over that cost.

Obama's view is that by not having a deemed disposition like Canada's, wealthy Americans are exploiting a loophole. Looking at it from just an income tax perspective, he's right – the pre-death gain is never subject to income tax. The deal has always been that estate tax is the price paid instead.

Now, Obama wants to capture the "lost" income tax as well. The way he will do it is by making the tax cost of an inherited asset equal to the decedent's tax cost. That way, when the asset is sold, the decedent's pre-death gain is caught.

What this means is that for a wealthy decedent bequesting –and a wealthy beneficiary inheriting – a low-tax-cost asset, the effective tax rate can be as high as 94% of the value of that asset – and that assumes the asset generates a long-term capital gain, not ordinary income upon sale.

This rate includes:

  • 40% Federal estate tax
  • 16% New York estate tax
  • 4.41% New York City income tax ( proposed by Mayor de Blasio)
  • 9.62% New York State income tax
  • 28% Federal income tax

The numbers do not directly add up to 94% because the state and local income taxes are deductible in arriving at federal taxable income. Of course, that deduction is limited for high-income people, so the effective tax rate can be even higher.

Political prospects

Obama's budgets have not fared well. Last year's was defeated in the house 413-2; it seems not even Democrats could vote for it.

This one is likely to face a similar fate, especially now that the Republicans control both the House and the Senate. "This is not a serious proposal" wrote Brendan Buck, a spokesman for House Ways and Means Committee Chairman Paul Ryan (R-WI). Senate Finance Committee Chairman Orrin Hatch (R-UT) also opposes tax hikes.

Given that this is the most Republican Congress since 1947, it seems unlikely that Obama's budget will meet with success. It appears to bepolitical "signaling", telling his base supporters that he's on their side, and that the evildoers opposite are in the employ of a wealthy oligarchy.

Based on the most recent elections, it seems the majority of Americans aren't buying this ploy. The divide between Republicans and Democrats continues to widen. Expect that trend to continue for 2016, where a "winner take all" mentality is likely to take hold. There is a significant possibility that the Republicans will hold the House, Senate and presidency all at the same time. This situation held for four of the Bush Jr. years, and for two years in the 1950s, but then one must go back to the early '30s to find another example of such Republican control.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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