FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
January 12, 2010

IN THIS ISSUE:

1.   Commentary by Kevin Hassett

2.   What if All Bush Tax Cuts Lapse?

3.   Soak the Rich?

4.   Capital Gains and Dividends Tax Rates to Rise

5.   When More Equals Less

6.   Targeting the Middle Class

7.   What’s a “Fair Share?”

Introduction

Unless something changes, Americans may be facing the largest tax increase in history at the end of this year.  Sadly, no members of Congress will have to vote on this massive tax increase, and President Obama will not have to sign it – it will happen automatically.  It happens at midnight on December 31, 2010 when the George W. Bush tax cuts expire.

Back in 2001 when the Republicans controlled Congress, President Bush was successful in pushing through major reductions in income tax rates, capital gains and dividends, increased tax credits and many other favorable tax provisions.  The Democrats couldn’t do anything to stop it, but they did invoke the so-called “Byrd Rule” which forced the Republicans to agree to a time limit for the new tax cuts.  Thus, the year 2010 was selected as the time the tax cuts would expire, unless extended by a future Congress.

Many Americans believe that if the Bush tax cuts are allowed to “sunset” at the end of this year, it will only affect wealthy Americans.  Yet the fact is that if all the Bush tax cuts expire at the end of this year, it will mean higher tax rates for ALL American taxpayers.  Sadly, those in the lowest tax brackets get hit the hardest (ie – the lowest 10% tax rate would jump 50% to 15%).

During the presidential campaign, candidate Barack Obama pledged to repeal the tax cuts. “I want to eliminate the Bush tax cuts,” Obama told CNN’s Wolf Blitzer in a May 2008 interview.  Obama also said, in a June 2007 Democratic debate at HowardUniversity, that repealing the Bush tax cuts would help pay for universal health care and other social programs he envisioned.  “The Bush tax cuts -- people didn’t need them, and they weren’t even asking for them, and that’s why they need to be less, so that we can pay for universal health care and other initiatives,” Obama said.

Yet President Obama also promised that he would keep the Bush tax cuts in place for those individuals making less than $200,000 and couples making less than $250,000.  This promise is badly broken if all the Bush tax cuts sunset at the end of this year.  As a result, some now believe Obama will only raise taxes on those in the top two brackets. 

However, Obama isn’t exactly batting a thousand on keeping his campaign promises.  Add to that the Senate’s failure to pass cap-and-trade legislation, one of the major sources of funding for Obama’s spending programs, and you get the real possibility that more than just the top two income tax brackets may see their taxes increased.  And remember, the tax cuts sunset automatically if Congress does nothing, subjecting American taxpayers to the largest tax increase in history.

This week, we’re going to tackle the thorny issue of taxation and the possibility that the Bush tax cuts will expire in their entirety come year-end.  We’ll start out with the reprint of a December Bloomberg article that helps to quantify the magnitude of the sunset issue.  While I don’t realistically expect all of the tax cuts to sunset, it will be interesting to see how Democrats reconcile their stated desire to control deficits and their promise to shield the middle class from tax increases.

Commentary by Kevin Hassett

QUOTE:

Jan. 4 (Bloomberg) -- The U.S. enters 2010 the way many bad movies end, by riding into the sunset.

Back in the early days of George W. Bush’s administration, opponents of his tax cuts were as helpless as Republicans have been during the health-care debate. But a U.S. Senate rule named for Democrat Robert Byrd allowed Bush’s opponents one seeming victory. To satisfy the Byrd rule, most of the tax cuts had to be considered temporary, so they were written to be rescinded in the then-distant year of 2010.

As bad as you might have felt on New Year’s Day, the goal of this column is to make you feel worse. Before reading further, you might consider grabbing the Excedrin. The list of tax provisions set to expire is long and significant.

Bush cut income tax rates, dividend tax rates and the capital gains tax. He reduced the estate and gift taxes, expanded the earned income tax credit, reduced the marriage penalty, expanded the child tax credit and allowed small businesses to deduct a more generous share of their expenses.

Those are just the big ones. An analysis by Congress’s Joint Committee on Taxation listed 113 tax provisions expiring in 2009 or 2010.

If you are married, have kids, have income or run a small business, your taxes are in play this year.

The question is, will Democrats let these sunsets happen? For some of the provisions, the crystal ball seems clear. With others, it’s anybody’s guess what might happen.

First let’s look at income taxes. During the campaign, President Barack Obama and most Democrats promised not to increase taxes on taxpayers with incomes below $250,000. Even though the Senate’s health-care bill clearly violates that pledge, it doesn’t constitute income-tax legislation in the most literal sense. It seems reasonable to expect that Democrats will otherwise try to honor Obama’s $250,000 floor.

That means the expanded earned income tax credit, the more generous child credit and all of the tax-rate reductions that apply to those with incomes below $250,000 are probably safe. Indeed, extensions of those tax breaks were incorporated into Obama’s long-term budget outlook last year.

If your income is above $250,000, on the other hand, horrors may await you. Major tax hikes appear inevitable, and the sunsets of 2010 are just the opening that Democrats need.

Here is the problem. Back in March, the Congressional Budget Office estimated that the tax provisions in Obama’s budget would increase the deficit by about $2 trillion over 10 years. That estimate counted on revenue from so-called cap-and- trade legislation that is now widely viewed as dead.

Making matters worse, the overall budget outlook has deteriorated since then. Policy changes and economic developments since March have increased the CBO’s baseline deficit over the next 10 years to $7.1 trillion from $4.4 trillion. Add in the extensions of the favored tax breaks, and that number climbs to almost $10 trillion. Somebody is going to be stuck with the bill, and if your income is above $250,000, you can bet it will be you.

If the Bush tax cuts expire, then the marginal tax rate on high incomes climbs to 39.6 percent from 35 percent. My guess is that technical tricks like phasing out deductions and imposing some version of a so-called millionaire surtax and war surtax get stuck in there too, perhaps lifting the top rate to around 45 percent.

That would be very bad news for equity markets. The tax rate on dividends received by those with high incomes is also set to jump from 15 percent to whatever the top income tax rate will be. This will be the largest increase in dividend taxes in history, severely undermining income from equities.

To be sure, during the campaign, Obama promised that he would lift the dividend tax only to 20 percent. Given that he is batting approximately zero for a thousand on the political promises he made to moderates, it seems unlikely that such a pleasant outcome will be achieved. By the way, the capital gains tax rate is going to go up as well, probably from 15 percent to 20 percent.  The estate tax is, as of this moment, zero. However, it seems likely that last year’s rate of 45 percent, on inheritances greater than $3.5 million for an individual, will be restored, retroactive to the start of this year.

All these tax hikes are a big deal for taxpayers, political handicappers, and economic forecasters.

For individuals, the best way to get ready is to load your income into 2010, before the tax rates go up. If you have capital gains, realize them. If you have a big bonus coming, don’t let it wait until 2011.

Economic forecasters will have to factor the higher taxes into their calculations. It seems likely that the recovery will be threatened by them late next year.

And political handicappers should ask themselves how low the approval of the Democrats will go in this election year. American politics has never seen an attempt to follow a massive and unpopular health bill with the mother of all tax increases. Until 2010, that is.

(Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He was an adviser to Republican Senator John McCain of Arizona in the 2008 presidential election. The opinions expressed are his own.)

END QUOTE

What if All Bush Tax Cuts Lapse?

First, let me state the obvious: the sunset provision related to the Bush tax cuts discussed in the article above is not news.  We’ve known about the 2010 sunset date since the Bush tax cuts were enacted in 2001 and 2003.  What is new to most people is the expanse of related tax provisions which accompanied the reductions in the actual income tax rates. 

According to the Joint Committee on Taxation report mentioned above, there are over 40 tax provisions in the Bush tax cuts that are currently set to expire at the end of 2010 alone.  Allowing the sunset of all of these provisions could negatively affect tens of millions of American taxpayers, including many lower-income taxpayers.

Just one example is the resetting of tax brackets back to Clinton-era levels.  Below are the various income tax brackets, plus what the old rates were before the Bush tax cuts.

*  Prior to the Bush tax cuts, there was no
10% bracket for lower-income taxpayers.

Any way you look at it, if all of the Bush tax cuts for all taxpayers are allowed to sunset, and brackets revert automatically to the 2000 rates, it would be the largest tax increase in history!  As you can see, if the Bush tax cuts expire, the rate increases on the lowest income filers from 10% to 15% would amount to a 50% increase. 

Even though many political analysts assume that Obama will keep his promise to maintain the Bush tax rates for couples making less than $250,000, it’s important to remember that doing so is going to require Congressional action.  The Bush tax cuts automatically sunset at the end of this year, so doing nothing will result in this massive tax increase, sure to be an election issue in 2012.

Taking action, however, is also fraught with peril.  If you liked the closed-door negotiations and political intrigue connected to the passage of the healthcare bill, then you’ll love the politics that are sure to come along with deciding which of the Bush tax cuts are allowed to sunset and which are allowed to continue, and to what taxpayer income levels they will apply.

Soak the Rich?

Of course, the ready answer that most Democrats have for raising more tax revenue is to further tweak the taxation of the rich, again defined as those making more than $250,000.  That is precisely why the Democrats only want to raise the top two brackets: 33% would go to 36% and 35% would go to 39.6%

The problem with that is raising the top two brackets only won’t generate nearly enough revenue to make a meaningful dent in the budget deficits (not that it matters all that much to Obama, apparently).  Since current proposals for raising taxes on only the “wealthy” don’t do enough to help bring down the trillion dollar deficits, we are hearing more ideas for additional taxes on the rich.

Ideas range from phasing out income tax deductions, to a “war surtax,” to a so-called “millionaire surtax” for those individuals and households that have incomes of $1 million or more in any given year.  This could easily raise the income tax rates on the wealthy to 45% or more.

Think I’m kidding?  Hardly.  The healthcare reform bill that passed in the House of Representatives (HR 3962) on November 7 includes a surtax of 5.4% on households with incomes of $1 million or more.  39.6% plus 5.4% gets you to 45% without a war surtax or a millionaire surtax.  If either is enacted, tax rates on the wealthy could easily top 50%.

I could spend the rest of this letter discussing why significant tax increases for only the rich don’t solve our problems, and in fact create some new ones.  Likewise, a huge healthcare tax increase of 5.4% on only 0.3% of the population doesn’t get us there either. 

However, I’ll leave you with just one thought regarding soaking the rich: many wealthy individuals enjoy an advantage called the “elasticity of taxable income.”  In other words, many wealthy individuals can choose how and when they take their income, usually basing such decisions on the various levels of taxation associated with each.

While most of us think of income as wages, commissions or self-employment income, many wealthy individuals have additional options available to them such as stock options, deferred compensation and others that allow them to select the timing and composition of their income.  The result almost always is that a large number of wealthy individuals shift to alternative forms of income to mute the effects of any tax increases.

Taxes on Capital Gains & Dividends to Rise Also

Prior to the Bush tax cuts, capital gains were taxed at 20% and stock dividends were taxed at your ordinary income rate (up to 39.6%).  Bush lowered both rates to 15%.  This, among other things, contributed to the impressive, multi-year bull market in stocks following the 2000–2002 bear market.

During the presidential campaign, candidate Obama said he would likely raise the capital gains and dividends tax rates from 15% to around 20%.  Now, however, with trillion dollar budget deficits as far as the eye can see, it would not surprise me to see him let those rates lapse back to the 28% rate applicable before 1997, if not even higher.

But it gets worse.  The House healthcare reform bill (HR 3962) applies the 5.4% surtax to capitals gains and dividends, as well as ordinary income.  Depending on whether the capital gains rate goes to 20% or 28%, the additional healthcare surcharge would take the cap gains rate to either to 25.4% or 33.4%.  The jump from 15% to 25.4% would amount to an increase of 69%, while a jump to 33.4% would amount to a more than doubling of the capital gains tax rate.  Such a disincentive to investing risk capital could prove to be devastating to the fragile economic recovery now underway, not to mention the re-election campaigns of those who vote to enact it.

When More Equals Less

The increase in capital gains tax rates may also have another nasty side effect – a negative pressure on tax revenues – which is the exact opposite of the desired result.  A recent Wall Street Journal article noted that capital gains tax revenues actually fell after an increase in the tax rates brought about by the Tax Reform Act of 1986.  However, capital gains tax revenues increased in the years following Bill Clinton signing legislation reducing the rate to 20% in 1997, and again under the Bush tax cuts that lowered the capital gains tax rate down to its current 15% level in 2003.

The reason tax revenues can vary so much is that capital gains taxes are paid only when appreciated assets held more than one year are sold and the gains are realized.  Investors often time the decision of whether or not to hold appreciated investments based on the prevailing income tax rates.  Thus, if Obama is successful in increasing the capital gains tax rate significantly, revenues may actually fall in the short term.

The same Wall Street Journal article noted that IRS statistical data from 2007 (latest available) show that 58% of overall capital gains revenue was reported by taxpayers with adjusted gross incomes of over $1 million.  As a general rule, wealthy individuals such as these do not need to sell appreciated assets to live on, so it’s entirely possible that they might hold onto appreciated property to see if tax rates go down in the future.

Supporters of increasing the capital gains tax rate point to estimates from the Congressional Budget Office and Joint Committee on Taxation predicting that changes to the capital gains tax rate is expected to have little impact on long-term revenue projections.  While this is doubtful, one thing is for sure: capital gains tax rates are anything but stable over the long term. 

Considering the frequency of recent changes in the capital gains tax rate (3 different tax rates since 1996 with another one on deck for 12/31/2010), wealthy investors may be more than willing to hold onto appreciated assets and wait out any increase in tax rates until the next election cycle. 

Targeting the Middle Class

Thus far, I have tried to point out how simply targeting the “rich” to pay for all of Washington’s spending indiscretions will not necessarily work to significantly lower the huge budget deficits.  Couple this with the lack of expected revenue from the cap-and-trade legislation and you get too little revenue to cover ever-increasing spending.

So, how do you think the Democrats and Obama administration will cover the gaps in an effort to try to live up to the promise of reducing out-of-control deficits?  Increase the corporate income tax rate?  Maybe, but the US already has one of the highest corporate income tax rates in the developed world.  The government would probably realize more corporate tax revenue if they decreased the rate, but that’s a story for a future E-Letter.

About the only resource left to raise tax revenues is to reduce the income thresholds on many of the provisions meant to tax the rich, which would result in middle class taxpayers helping foot the bill for Obama’s spending spree.  Of course, you won’t find this in any current proposals from the Obama administration or the Congressional Democrats.  Such an admission could be political suicide, but they may do it anyway in the future.  After all, the House and Senate both passed versions of healthcare reform legislation despite widespread public disapproval.

What’s a “Fair Share?”

In respect to Congress, sometimes doing nothing is the best thing you could hope for.  This is especially true in regard to the recent healthcare legislation “debate,” where bribes and payoffs for votes were common, and neither the Senate nor House bills are fully understood.  However, in the case of the Bush tax cuts, congressional inaction could lead to one of the largest tax increases in history.

Even worse, if all of the Bush tax cuts are allowed to lapse for all taxpayers, lower-income individuals would be hit much harder than the upper income taxpayers so popularly demonized by liberals.  In closing this E-Letter, I want to share some thoughts that I saw while researching materials for this article.  Many Internet articles now include responses from readers, but I usually never read them.  This time, however, I took the time to read some responses, and they proved to be very telling of the national mood.

First, there is little sympathy for Wall Street fat cats and deservedly so.  These villains that nearly bankrupted the US economy were bailed out with your and my tax dollars just over a year ago.  Given access to virtually interest-free money from the Fed, they are now running record profits and paying out billions of dollars in bonuses.  Oh, and don’t forget that part of your tax money is being spent on lobbying efforts that have, so far, successfully stalled any meaningful regulatory reform that would prevent future economic meltdowns.

Related to that, however, is a general resentment of the wealthy, which the Obama administration has conveniently defined for us as anyone making over $250,000 per year.  I wish I had a nickel for every comment saying, in effect, “it’s about time the rich pay their fair share of income taxes.”  Oh really?

I have reproduced below a chart that I have mentioned many times in my writings.  It is based on IRS income tax data from 2007 (latest available) and shows the percentage of income taxes paid by various demographic groups based on adjusted gross income:

Notice that the top 1% of income earners - adjusted gross income of more than $410,096 - pay over 40% of all income taxes paid.  How is 40% not their fair share?  Next notice that the top 25% pay over 86% of all income taxes paid.  Notice further that the top 50% of taxpayers pay over 97% of all income taxes paid.  Yet liberals believe they should pay even more.  

Compare those percentages with the bottom 50% of taxpayers who pay less than 3% of all income taxes.  Actually, the term “taxpayers” is probably a misnomer, since separate data from the IRS show that, of the 141 million-plus tax returns filed in 2007, approximately 47 million either owed no tax or actually received refundable credits that resulted in a negative tax rate.

If the top 50% of taxpayers are responsible for paying over 97% of all income taxes, I find it hard to imagine what their “fair share” should be if this isn’t sufficient.

In the past, some have responded to this information saying that those in lower income brackets pay Social Security and Medicare taxes, which (they say) unfairly loads the cost of that program on the backs of lower-paid taxpayers.  The problem with this argument is that it compares apples and oranges.  Income tax revenues are designed to fund the functions of government while payroll tax revenues were originally designed to build a “safety net” retirement payment. 

Conclusions

Having watched the healthcare bill “debate” process, I can’t help but get an ill feeling when I consider what might happen to tax policy in general, and the expiration of the Bush tax cuts in particular.  Congressional tweaking of the income tax code invariably results in an even more complex document that most of our elected officials can’t understand.  Of course, that’s not likely to keep them from doing something, even if it’s wrong.

My greater fear, however, is that Congress goes through the motions of pretending to want to extend the Bush tax cuts for lower-paid individuals while socking it to the wealthy, but then having time run out and the tax cuts fade into the sunset, literally.  The House and Senate need take no action for one of the largest tax increases in history to fall upon us come January 1, 2011.  Will they muster the political will to do it?  Who knows?

On the other end of the spectrum, however, are rumblings about scrapping the entire tax code in 2010 and replacing it with something better.  Back in 2009, House Speaker Nancy Pelosi admitted on The Charlie Rose Show on PBS that a “value added tax” (VAT) was on the table for consideration.  This is not the first time alternative tax code proposals have been made. The value added tax, “Fair Tax,” and “Flat Tax” proposals have been buzzing around Washington for years.  I did an analysis on the Flat Tax and Fair Tax proposals in my April 17, 2007 E-Letter.  Reading this analysis would be a good way to become familiar with these proposals.

What the income tax code will look like at the end of 2010 is anybody’s guess, but it’s going to be an interesting process to watch.  Stay tuned to my weekly E-Letters as I will be bringing updates as they happen over the course of the year.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

How Obama's routing the recovery
http://www.nypost.com/p/news/opinion/opedcolumnists/how_obama_routing_the_recovery_zneMnksB1VnHzSS7QmuhnL

Healthcare: Another $222 Billion, Ho Hum
http://online.wsj.com/article/SB10001424052748703652104574652563562216036.html?mod=WSJ_Opinion_AboveLEFTTop

Labor & Obama in "Cadillac" Healthcare Tax Fight
http://www.foxnews.com/politics/2010/01/11/irate-labor-leaders-press-obama-proposed-health-care-cadillac-tax/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%253A+foxnews%252Fpolitics+%2528Text+-+Politics%2529

• Like us on Facebook
• Share on Facebook
• Share on Twitter