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With the latest Congressional soap opera of the payroll tax extension now mercifully behind us, we can turn our attention to a much bigger tax policy question that is just beginning to occupy the minds of investors: will the lower Bush era taxes on long-term capital gains and qualified dividend income (QDI) be extended next year, modified or allowed to expire?

Just like predicting future interest rates, knowing the direction of future federal tax policy is no easy task, but I'm growing increasingly skeptical that QDI can survive in its current form much longer.

History of Qualified Dividends and Current Rate Structure

Following the tech boom and bust, there were many tax policy debates in 2002 and 2003. One of them focused on lowering the rates investors paid on corporate dividends. There were two principal policy rationales offered for this: first, corporate dividends were already taxed once as corporate profit and shouldn't be taxed again as investment income. Second, with equity markets still recovering from the tech bust, a significant reduction in tax rates for equity dividends would increase demand for stocks over fixed income investments and stimulate capital formation.

In 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) which reduced the rate on qualified dividends from ordinary income tax rates to long-term capital gains rates: 5% for those in the 10% or 15% tax brackets and 15% for those in higher brackets. In 2008, the 5% rate was lowered to 0% for taxpayers in the bottom two tax brackets Both of these rates are set to expire at the end of 2012.

What's the future of QDI?

Beyond this end of year sunset provision which affects not just QDI but other key tax rates and deductions, I think there are four reasons to question whether lower QDI rates can survive beyond their current planned expiration:

1. The combination of recent economic improvements along with a very contentious and prolonged Republican primary favor Obama for reelection. Obama has already made it clear that he will not extend all the Bush era tax cuts in their current form and if forced to negotiate, I suspect Congressional Republicans will sacrifice in favor of preserving more important lower tax rates like capital gains.

2. The benefits of QDI dramatically skew to top income earners. As we saw recently with the release of Mitt Romney's tax return, affluent investors can build a QDI-oriented portfolio and enjoy a tax rate that's 50% lower than many middle income working Americans. I don't see how this plays well in an election year where so many families have seen stagnant wages the past decade with rising healthcare and education costs.

3. QDI is on the wrong side of the "broaden and simplify" consensus that's emerging in Washington. Both Democrats and Republicans seem to be moving toward tax code simplification and broadening the base after the election. Though Republicans favor doing this through eliminating loopholes and inefficient deductions and Democrats favor raising rates on higher income taxpayers, it's hard to see how QDI will be viewed as a "must have" on either side of the aisle.

4. It's not clear from a tax policy perspective that QDI is nearly as useful as other tax reforms for achieving its original policy objective. Unlike lower capital gains tax rates, for example, which are more clearly linked to equity risk and capital formation, it's not at all clear that favoring dividend income over other income -- particularly earned income -- is as beneficial. Given that nearly 75% of qualified dividends are paid to tax exempt institutions and some of the remaining amount held in tax deferred accounts where the lower QDI tax rate will never be realized, it's easier to see how the vast majority of the benefit is accruing to such a small number of high (qualified) income taxpayers.

What events might favor a QDI extension?

Well, perhaps two things:

1. If the economy weakens over the next year, the same argument that favored extension of the payroll tax cuts and other lower tax rates may hold sway, but that's probably just a temporary reprieve.

2. Lower income investors, particularly senior citizens, have come to rely on the 0% tax rate, which is an especially useful after-tax boost in the current low interest rate environment. We could see some sort of carve out for lower tax bracket investors, though a more efficient way to implement that would be to just exempt all investment income up to a specific dollar amount for retirees or other lower income taxpayers.

How can you prepare your portfolio for a change in QDI tax rates?

This is one of the harder questions to answer until we have more clarity on overall future tax policy -- not just QDI. For example, I wouldn't advocate a wholesale change to your equity holdings now based on incomplete information, particularly if it involves the trade-off of paying capital gains taxes to make adjustments. On the other hand, if you are significantly overweighted to high dividend paying stocks and sectors that saw their valuations rise with the implementation of QDI, you may want to adopt a more balanced approach to your income portfolio to hedge some of this future tax uncertainty.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.