[IMGCAP(1)]Investors have a bit more to ponder as the administration rolls out its tax program, designed to both address the federal budget deficit and promote economic development.

When the Obama budget was rolled out this spring, it called for more spending on non-defense research, education and things such as roads and bridges and other infrastructure items. It featured some cuts to Social Security and Medicare and higher taxes on the wealthy.

“We can grow our economy, and shrink our deficits,” the President was quoted as saying.

When one analyzes the administration’s proposals, you can see the intent behind the President’s comment. And while the House and the Senate have forwarded their own very different proposals, it’s useful to see which way the taxation wind is blowing to gain an insight on what actually will adopted and affect the actions of investors.

First, the administration wants to make accelerated depreciation permanent. This is where you can essentially write off 100 percent of a capital investment after the first year. It’s not an insignificant tax rule. Corporations paid about the same amount in taxes that they received benefits for, about $181 billion. A large portion of that benefit was from two items: Deferring income offshore and additional first-year depreciation with a limit of $500,000. Companies are encouraged by this to buy new equipment, thereby stimulating the economy.

Pro-U.S. Small Business and Renewable Energy
Another pro-business, pro-investment policy is the permanent extension of the research and development tax credit and the proposal of raising it to 17 percent. This credit is one of those that have annual sunsets and Congress renews them for another year, only to deal with them next year. By making the credit permanent, it gives credit for individual creativity for new products that benefit the American public.

The administration also wants to permanently extend the Work Opportunity Tax Credit, a 20 percent credit on qualifying wages for certain individuals. There’s also a one-time, temporary 10 percent tax credit for a small business that hires new employees or increases wages and a permanent exclusion for 100 percent of small business stock sales. Another thing the administration wants to do is to push savings by requiring employers with more than two years in business and more than 10 employees to enroll their employees in a direct deposit IRA and receive a $25 tax credit for doing it.

There are also some taxes or revenue-raising ideas that involve businesses in the plan. Last-in-first-out inventory accounting would be repealed and the valuation that uses the lower cost of market would be banned, which would have the effect of increasing revenues and related taxes. They want to tax carried partnership interest as ordinary interest and eliminate loopholes in importing carried losses into related-party partnerships and to repeal the technical partnership termination rules, which have been seen as vulnerable to fraud.

When it comes to manufacturing, the administration continues to support renewable energy, including $2.5 billion in tax credits for qualified property investments and making the renewable production tax credit permanent. It wants to install measures to promote investment in the U.S. with credits and disallow deductions for expenses incurred in connection with outsourcing a U.S. business. 

The President also takes aim—I think futilely—at the domestic fossil fuel business by suggesting we repeal the enhanced oil recovery credit; the credit for oil and gas produced from marginal wells; expensing of intangible drilling costs; the deduction for tertiary injectants and the percentage depletion for oil and natural gas wells, among other things.

Estates and individuals
Steve Wyett, senior vice president of portfolio management at BOK Financial, said recently that the Congressional Budget Office is predicting the budget deficit in 2013 to go to $642 billion, a $200 billion improvement. He called the deficit “unsustainably large. We’ve got to reduce that gap.”

Taxes control budgets, which control spending, which controls deficits, so if the government is going to attack the deficit it has to raise taxes. The administration wants to raise taxes on the wealthy: by reducing itemized deductions to 28 percent for families in the top three income brackets; by imposing the Buffet Rule where millionaires pay no less than 30 percent of their income in taxes; and capping IRA account values that would provide a 62-year-old person with $205,000 in annual income.

In the estate planning area, the administration wants to, beginning in 2018, return the generation-skipping transfer and gift tax exemption rates to 2009 levels, with a top rate of 45 percent and an exclusion amount of $3.5 million (down from $5.2 million) and $1 million for gift taxes. The President also proposes to reduce the life of a trust from 1,000 to 90 years, thus reducing generation-skipping tax exemptions. These measures have been proposed in years past. It will be difficult to lower the exemption from $5.2 million once it has been in place.

On the revenue side, the biggest effect would be to change how the government measures inflation from the Consumer Price Index to a “chained CPI,” seen as a more accurate measure because it takes into account how people buy cheaper items when stressed. Chained CPI has the effect of lowering the inflation measurement, and this would lower the inflation-adjusted benefits of Medicaid and Social Security benefits. So the government would spend less. It would also slow the increase in inflation-adjusted allowable deductions for the wealthy.

Given this tax and spending backdrop, what is an investor to do in 2013? Wyett said that the traditional haven for the wealthy, corporate and municipal bonds and government securities, are a bad choice. In fighting deflation, all of the government easing of the money supply has been the response and will continue to occur until unemployment is 6.5 percent and prices are stable, say at about 3 percent inflation. When inflation and interest rates inevitably rise, the principle value of bonds will decrease, plus that 2 percent Treasury note coupon won’t look so attractive against an even modest inflation rate.

“Despite highs in the S&P and the Dow, stocks will provide the opportunity for growth. Bonds provide no growth opportunity,” Wyett said. “If I buy a $100,000 bond today, it’s going to mature in 10 years and I know exactly what I’m going to get, absent a credit event: 100,000 bucks.”
He noted the average earnings ratio on stocks is at 14 percent, below historical highs.

“Bonds are not riskless. We don’t believe higher interest rates are a 2013 story, maybe not even 2014, although we hope they pull back on quantitative easing,” Wyett said. “The longer your investment horizon, the more favorable outlook is for equities than bonds.”

But don’t forget the government seems more bent on promoting investment on small business and on taxing passive investments. It has already raised capital gains to 20 percent and the wealthy get to pay 3.8 percent more of the alternative minimum tax. Oh well, at least we know that nothing is permanent when it comes to taxation. If your investment horizon is longer than a few years, the picture will likely be different by the time it comes to cash in.

Mira Finé, CPA, is the national director of tax operations for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas and Orange County. She specializes in succession planning and can be reached at mfine@heincpa.com or (303) 298.9600.