Tax on Hope Chills Next Generation of Investors

Dec. 31 (Bloomberg) — To a lot of investors, 2009 looks like twilight at the bottom of the ski run. Ahead is the icy walk down to the parking lot and the challenge of maneuvering the car out of the resort without crushing someone's fender.

Even the gloomiest among us can take comfort in knowing that there is one group for whom 2009 is all early morning and fresh powder. That group is young investors, especially the truly young — 18, 19, 20. They have no losses to straighten out. They can pick up real estate at prices unseen for years. They can collect stocks at prices inaccessible to their forerunners.

All they have to do is bend their knees and keep their skis straight and it will be compound, compound, compound all the way down the mountain.

Or would be, but for a levy discussed mostly in the personal-finance columns. It is the Kiddie Tax.

The tax applies to so-called unearned income, from dividends, investments and capital gains. Back in the 1990s and the early part of this decade, children under 14 who had such income paid taxes at the parental rate. Teenagers or college students, however, were taxed at a much lower rate.

In recent years — even as it lowered capital-gains rates for modest earners — Congress moved to subject more to the parental-level Kiddie Tax. First, lawmakers raised to 18 the age at which young investors could escape their parents' rate. Then they raised the cap again, so that, in the 2008 tax year, full-time students who made more than $1,800 in investment income and are under age 24 also had to pay at their parents' rate.

Parking Money

To avoid this penalty and break free of the family tax rate, young people must ensure that the majority of their income is "earned" — that is, it comes from a salary. Or they must pass up full-time school.

The motivation of the tax writers is obvious. Parking money with kids to get a better rate is a time-honored American tradition. Since tax rates will doubtless rise in coming years, such parking is only going to become more attractive. Capitol Hill staffers reckoned that the Kiddie Tax could haul in $2 billion over 10 years.

The Kiddie Tax also fits the zeitgeist, and perfectly. The stereotype of offspring with investment income was pretty ugly even before every American knew the name "Madoff." (Such teen moguls were viewed in the same category with snowboarders who hog the train with their showy 360s. Off the slope with them!)

Finally, there's the argument that the tax applies to such a small crowd that it's a mere pebble in the economic path.

Stifling Entrepreneurs

In fact, the Kiddie Tax is more than a pebble. After all, infant rentiers are not the only young people at issue here. There are also entrepreneurs pursuing higher education, reasonably enough. Some may be future Madoffs or Jeff Skillings but also may turn into the next Bill Gates, Michael Steinhardt, Bruce Kovner or Warren Buffett.

These young people are better equipped than just about anyone in society to take big risks for big rewards. And at this moment they really are standing on the mountaintop of their career, looking down, trying to decide whether to follow a path labeled "law," one labeled "construction engineering," or the least predictable one, labeled "finance."

To them, the Kiddie Tax says: this perilous finance route is not worth it. If you take a regular job in the dining hall, you'll pay lower rates. Or if you invest just a little, you'll pay low rates, too. So why endure the extra penalty of 30 percent, 40 percent, or even 50 percent marginal tax rates? Go for the law, or be a salary man, or just stay at home and be the lazy guy your father already thinks you are.

Royal Brush-Off

And escape the opprobrium of the rest. After all, everyone from the Queen of England on down these days is trashing that third path. In her list of Honours this week, Her Highness is said to be pointedly omitting the stars of the City of London. The message is clear: in 2009 only selfish people go into finance.

That argument is wrong. To grow again, the economy requires more than stimuli; it needs innovation. Very few people in a wage job come up with an innovation. You need the engineers and the finance hotshots. And only innovation leads to the sort of productivity gains that can help the economy recovery solidly.

So the Kiddie Tax isn't just a tax on stocks. It's a tax on hope, one that kills fun. After all, it is when people play that they happen on some of their most monetizable insights.

What distinguishes a Bunny Slope economy from a Black Diamond economy is that, in the latter, minds are allowed to be "venturesome," the quality captured by economist Amar Bhide in his new book. To remain a Black Diamond, the U.S. economy needs young investors — venturesome ones. Their run is our run, as well.

(Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2008 Bloomberg

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