How Washington Should Handle the Bush Tax Cuts

[Editor's Note: When it comes to explaining the nexus of business and politics, Money Morning's Martin Hutchinson is unmatched. Months before the actual events, Hutchinson correctly predicted the outcomes - and the investment impact - of the U.S. presidential primaries and the general election. And he recently did the same for Great Britain. Now he turns his attention to the Bush tax cuts, which are set to expire at the end of December.]

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The big political issue for the remainder of this year will be the so-called "Bush tax cuts" engineered by U.S. President George W. Bush in 2001 and 2003.

Those tax cuts are scheduled to expire on Dec. 31, with taxes reverting to their 2001 levels.

It's not at all clear which of the cuts will be extended and which will be repealed.

But one thing is clear: The outcome of the Bush-tax-cut debate will have major implications for the U.S. economy.

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[...] Money Morning News Analysis: How Washington Should Handle the Bush Tax Cu…

Most of the money represented by the Bush tax cuts consists of the income tax cuts of a few percentage points on incomes of less than $250,000, as well as a major liberalization of the rules governing Individual Retirement Accounts (IRAs). A key part of the IRA liberalization lifted the annual contribution limit from $2,000 to $5,000.

The Bush tax cuts also raised the minimum income levels on the Alternative Minimum Tax (AMT). Congress wrote the AMT rules to keep wealthy Americans from taking too many deductions. But Congress failed to account for inflation and during the past 40 years, millions of U.S. middle-class taxpayers have been tripped up by AMT.

Given President Obama's pledge not to raise taxes for those earning less than $250,000, these elements of the Bush tax cuts are likely to be extended, at least for a few years (the AMT limit increases have been extended annually for some years now). The Democratic leadership in both houses of Congress has indicated that it wants to extend these tax cuts and the AMT limit increases, so you would think that a Congressional majority would be pretty easily obtainable.

However, in the aftermath of the worst financial crisis since the Great Depression, nothing is simple. So even though there is a majority for extending the under-$250,000 income tax cuts, the IRA tax cuts and the AMT limit increases, it may not happen.

Handicapping the New Tax Plan

The easiest time to get the Bush tax cuts extended will be during the period that precedes the midterm elections this November, a time during which Democrats will want to reassure U.S. voters that they don't object to tax cuts on principle.

However, since Republicans will be claiming that the Democrats do object to tax cuts on principle, it is possible deadlock will occur, and the question be left until the "lame-duck" session after the elections. If this happens, the political cost of not ending the tax cuts will be much less: By November 2012, which is when the next election takes place, voters will have forgotten about the events of November/December 2010.

What's more, President Obama's deficit commission (known officially as the Bipartisan Commission on Fiscal Responsibility and Reform) reports on Dec. 1. And if that commission recommends tax increases - a very real possibility - then extending the 2001 tax cuts may become impossible.

Thus, even with these generally agreed tax cuts, the chance of not extending them is significant. If they are not extended, the drag on the economy will be considerable, even though raising taxes will reduce the U.S. federal deficit.

At the opposite end of the public opinion spectrum from these "popular" 2001 tax cuts is one that takes the levy on so-called "high earners" and reduces it from 39.6% to 35%. It is generally assumed that with a Democrat majority in both House and Senate and a huge deficit problem, these cuts will be allowed to expire.

In recent days, however, a few Democrats have indicated they would like to extend them. I'd put the odds of success at maybe 10%. Even at 39.6%, the U.S. income tax on high-earners is fairly low. So I'd rate the economic effect of not extending them as pretty small: By budget-deficit-reduction standards, the amount of money involved isn't substantial.

Estate taxes are a difficult issue. Before 2001, they were levied at 55% on estates in excess of $1 million. This estate levy came down in stages, and was finally abolished altogether this year.

President Obama has recommended restoring the 2009 tax, which taxes estates at a 45% rate with a $3.5 million exemption. Republicans prefer a 15%-20% rate; it is possible Congress will choose something in between.

Although the amounts of money involved are again small, the estate tax has important economic consequences. For one thing, billionaires take steps to avoid it, thus creating innumerable charitable foundations. On the other hand, at 55% or even 45%, it can prove fatal to many small businesses that must be passed from the founder to the next generation.

In our book "Alchemists of Loss" (Wiley 2010), co-author Kevin Dowd and I claim that heavy estate taxes have pushed the United States from shareholder capitalism to managerial capitalism. Once this change takes place, company managements control the purse strings, with no individual shareholders powerful enough to keep them in line. Adam Smith showed that shareholder capitalism works well; recent events suggest that managerial capitalism does not work anywhere near as well.

The economic benefits of abolishing the estate tax, or reducing it to manageable levels of roughly 15%-20%, would thus be very considerable. Charities are fearful of losing their funding stream; that's why they are clamoring to have the tax restored. The clear benefits of abolishing or reducing it should be enough for us to push Washington to make the correct move.

Finally, the 2003 Bush tax cuts - which reduce taxes on dividends and capital gains to 15% - also expire Dec. 31, if they aren't renewed. With no renewal, the capital-gains levy would increase to its 1997 level of 20%. Dividends would be taxed as "ordinary income," at rates up to and including 39.6%.

In his 2011 budget, President Obama wanted to preserve dividend tax cuts for those making less than $250,000, while allowing them to lapse for high earners. However, capital-gains taxes would revert to 20% for everybody. 

Raising capital gains tax rates to 20% isn't a big problem; the problem here is the dividend taxes. Corporate earnings are already taxed at 35%, so if dividends are taxed as ordinary income, the total tax rate is 61%. That's excessive by any standards - and that still doesn't factor in taxes that states may levy on the dividend payouts

A Plan That Works

In a sensible system, dividends paid would be deductible from corporate income for corporate tax purposes. That would eliminate corporate-tax shelters because shareholders would object to them. It would also make corporate debt less attractive and reduce the power of management, both good things. However, a preferential 15% individual tax rate on dividends is a partial move in the right direction. Eliminating this benefit would encourage stock options, leverage and the bubble mentality that is already too strong among corporate management.

Even assuming Congress acts to extend some of the tax cuts, the chances are that the estate tax and dividend taxes will revert to a level that is economically damaging. Such is the result of the Bush administration and Congress playing idiotic political games in which tax cuts are passed temporarily rather than made permanent.

Most of the money represented by the Bush tax cuts consists of the income tax cuts of a few percentage points on incomes of less than $250,000, as well as a major liberalization of the rules governing Individual Retirement Accounts (IRAs). A key part of the IRA liberalization lifted the annual contribution limit from $2,000 to $5,000.

The Bush tax cuts also raised the minimum income levels on the Alternative Minimum Tax (AMT). Congress wrote the AMT rules to keep wealthy Americans from taking too many deductions. But Congress failed to account for inflation and during the past 40 years, millions of U.S. middle-class taxpayers have been tripped up by AMT.

Given President Obama's pledge not to raise taxes for those earning less than $250,000, these elements of the Bush tax cuts are likely to be extended, at least for a few years (the AMT limit increases have been extended annually for some years now). The Democratic leadership in both houses of Congress has indicated that it wants to extend these tax cuts and the AMT limit increases, so you would think that a Congressional majority would be pretty easily obtainable.

However, in the aftermath of the worst financial crisis since the Great Depression, nothing is simple. So even though there is a majority for extending the under-$250,000 income tax cuts, the IRA tax cuts and the AMT limit increases, it may not happen.

Handicapping the New Tax Plan

The easiest time to get the Bush tax cuts extended will be during the period that precedes the midterm elections this November, a time during which Democrats will want to reassure U.S. voters that they don't object to tax cuts on principle.

However, since Republicans will be claiming that the Democrats do object to tax cuts on principle, it is possible deadlock will occur, and the question be left until the "lame-duck" session after the elections. If this happens, the political cost of not ending the tax cuts will be much less: By November 2012, which is when the next election takes place, voters will have forgotten about the events of November/December 2010.

What's more, President Obama's deficit commission (known officially as the Bipartisan Commission on Fiscal Responsibility and Reform) reports on Dec. 1. And if that commission recommends tax increases - a very real possibility - then extending the 2001 tax cuts may become impossible.

Thus, even with these generally agreed tax cuts, the chance of not extending them is significant. If they are not extended, the drag on the economy will be considerable, even though raising taxes will reduce the U.S. federal deficit.

At the opposite end of the public opinion spectrum from these "popular" 2001 tax cuts is one that takes the levy on so-called "high earners" and reduces it from 39.6% to 35%. It is generally assumed that with a Democrat majority in both House and Senate and a huge deficit problem, these cuts will be allowed to expire.

In recent days, however, a few Democrats have indicated they would like to extend them. I'd put the odds of success at maybe 10%. Even at 39.6%, the U.S. income tax on high-earners is fairly low. So I'd rate the economic effect of not extending them as pretty small: By budget-deficit-reduction standards, the amount of money involved isn't substantial.

Estate taxes are a difficult issue. Before 2001, they were levied at 55% on estates in excess of $1 million. This estate levy came down in stages, and was finally abolished altogether this year.

President Obama has recommended restoring the 2009 tax, which taxes estates at a 45% rate with a $3.5 million exemption. Republicans prefer a 15%-20% rate; it is possible Congress will choose something in between.

Although the amounts of money involved are again small, the estate tax has important economic consequences. For one thing, billionaires take steps to avoid it, thus creating innumerable charitable foundations. On the other hand, at 55% or even 45%, it can prove fatal to many small businesses that must be passed from the founder to the next generation.

In our book "Alchemists of Loss" (Wiley 2010), co-author Kevin Dowd and I claim that heavy estate taxes have pushed the United States from shareholder capitalism to managerial capitalism. Once this change takes place, company managements control the purse strings, with no individual shareholders powerful enough to keep them in line. Adam Smith showed that shareholder capitalism works well; recent events suggest that managerial capitalism does not work anywhere near as well.

The economic benefits of abolishing the estate tax, or reducing it to manageable levels of roughly 15%-20%, would thus be very considerable. Charities are fearful of losing their funding stream; that's why they are clamoring to have the tax restored. The clear benefits of abolishing or reducing it should be enough for us to push Washington to make the correct move.

Finally, the 2003 Bush tax cuts - which reduce taxes on dividends and capital gains to 15% - also expire Dec. 31, if they aren't renewed. With no renewal, the capital-gains levy would increase to its 1997 level of 20%. Dividends would be taxed as "ordinary income," at rates up to and including 39.6%.

In his 2011 budget, President Obama wanted to preserve dividend tax cuts for those making less than $250,000, while allowing them to lapse for high earners. However, capital-gains taxes would revert to 20% for everybody.

Raising capital gains tax rates to 20% isn't a big problem; the problem here is the dividend taxes. Corporate earnings are already taxed at 35%, so if dividends are taxed as ordinary income, the total tax rate is 61%. That's excessive by any standards - and that still doesn't factor in taxes that states may levy on the dividend payouts

A Plan That Works

In a sensible system, dividends paid would be deductible from corporate income for corporate tax purposes. That would eliminate corporate-tax shelters because shareholders would object to them. It would also make corporate debt less attractive and reduce the power of management, both good things. However, a preferential 15% individual tax rate on dividends is a partial move in the right direction. Eliminating this benefit would encourage stock options, leverage and the bubble mentality that is already too strong among corporate management.

Even assuming Congress acts to extend some of the tax cuts, the chances are that the estate tax and dividend taxes will revert to a level that is economically damaging. Such is the result of the Bush administration and Congress playing idiotic political games in which tax cuts are passed temporarily rather than made permanent.

Actions to Take: For investors, the recommendations are obvious.

  1. Take as much of your income as possible during 2010.
  2. Convert your IRA (tax-deductible contributions, taxable distributions) into a Roth IRA (after-tax contributions, tax-free distributions) and gladly pay the tax for doing so (that is allowed for "high earners" only this year).
  3. But don't take advantage of the special deal that allows you to pay the tax in 2011 and 2012; the tax rates you pay will almost certainly be higher.
[Editor's Note: Why is it that Money Morning's Martin Hutchinson has been right on the money with every one of his political predictions for each of the last three years?

The answer is quite simple. The same skills that made him a successful global merchant banker - where he was easily able to identify winning trends for his clients - also make him one of the very best political prognosticators.

Just look at some of his most recent global predictions. Earlier this year, just a week after Hutchinson recommended Germany, the European keystone reported much stronger-than-expected GDP. He recommended Chile back in December, and three of the stocks he highlighted have posted strong, double-digit returns - and one is up nearly 25%. He again recommended Korea - which analysts were downgrading - only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.

A longtime international merchant banker, Hutchinson has a nose for profits instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

Take a moment to find out more about "Alpha-Bulldog" stocks and The Permanent Wealth Investor by just clicking here. You'll the time well spent.]

News and Related Story Links:

Actions to Take: For investors, the recommendations are obvious.

  1. Take as much of your income as possible during 2010.
  2. Convert your IRA (tax-deductible contributions, taxable distributions) into a Roth IRA (after-tax contributions, tax-free distributions) and gladly pay the tax for doing so (that is allowed for "high earners" only this year).
  3. But don't take advantage of the special deal that allows you to pay the tax in 2011 and 2012; the tax rates you pay will almost certainly be higher.
[Editor's Note: Why is it that Money Morning's Martin Hutchinson has been right on the money with every one of his political predictions for each of the last three years?

The answer is quite simple. The same skills that made him a successful global merchant banker - where he was easily able to identify winning trends for his clients - also make him one of the very best political prognosticators.

Just look at some of his most recent global predictions. Earlier this year, just a week after Hutchinson recommended Germany, the European keystone reported much stronger-than-expected GDP. He recommended Chile back in December, and three of the stocks he highlighted have posted strong, double-digit returns - and one is up nearly 25%. He again recommended Korea - which analysts were downgrading - only to have the traditionally conservative International Monetary Fund (IMF) come out with an upgraded forecast that projects solid growth for that Asian Tiger for this year and next.

A longtime international merchant banker, Hutchinson has a nose for profits instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show investors the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson puts those global-investing instincts to good use. He's managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

Take a moment to find out more about "Alpha-Bulldog" stocks and The Permanent Wealth Investor by just clicking here. You'll the time well spent.]

News and Related Story Links:

About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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