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It's not at all clear which of the cuts will be extended and which will be repealed.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

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:

Join the conversation. Click here to jump to comments…

  1. Loren Smith | August 20, 2010

    About a sensible system, dividends paid should be tax deductible, but also, dividends earned should be taxable. How about eliminating 2/3 of the second page of the corparate tax form and replacing it with the sentiment in the first sentence? It would certainly promote dividend payouts. It is possible to retain something of the capital gains aspect by allowing 5-10% of the distribution to be a reduction in basis. It would work something like depreciation on real estate and business property.
    Loren Smith, EA (25 years in the tax prep. business)

    • William Patalon III | August 20, 2010

      Dear Loren:
      Great response! Articulate, well-thought-out and well presented. Thank you for taking the time to post.
      William Patalon III
      Executive Editor
      Money Morning

  2. Dave | August 20, 2010

    On the whole, this is a good analysis, free of much of the emotion of typical discussions.
    However, the analysis doesn't raise the distinction between corporate earnings reported to Wall Street (which are manipulated) and those reported to the IRS (also manipulated). Corporations have such latitude in their deductions that paying taxes on earnings is an option. If taxpayers had the same opportunity for deductions, their tax burden would be much less. Looking through the Morningstar database for stocks, I found 2200 out of 11316 companies that paid any taxes for last year. Of those, 1217 paid the 35% rate. So, roughly ten percent of all the companies listed paid the full rate. The answer to paying little or no income tax is to incoporate.
    For those who have worked in closely held businesses, this is obvious. Owners often take money out of the company in perks and questionable expenses, rather than a large salary.
    The dividend tax cut actually took taxable earnings into account. Classifying dividends as qualified or not qualified depending on whether the corporation paid taxes. This eliminates the "double-taxation" without being a taxpayer-funded gift to corporations that paid no tax.

  3. JJ | August 20, 2010

    How about giving stock investors the same break as housing.A max $250K single/$500K couple tax free gain every 2 years.We need productive assets more than homes at this time.

  4. fallingman | August 20, 2010

    Good point re: shareholder capitalism vs. managerial capitalism.

    If I may take issue with one assertion offered as if it's a fact…

    "Even at 39.6%, the U.S. income tax on high-earners is fairly low."

    I get the point … that relative to the levels that obtained previously, they aren't as high.

    You're English, aren't you? You folks nearly destroyed your productive class and drove them overseas with your confiscatory levels of taxation, so I can understand how 39.5% might look low to you.

    But 39.5% of income to feed the insatiable and insane beast in Washington is waaaaay too high. This monster needs to be starved. The extra tax dollars just enable them to do more harm. And 39.5% is plenty high enough for plenty of people to say, "Screw it, why am I killing myself working 60-70 hours a week so I can provide a comfortable living for a bunch of rent seekers in Washington and the corporatist boyz club they work for?"

    The motto of the F.U.S. government has become "JP Morgan and Goldman Sachs uber alles."

    When my own total taxation level went to right around 50% back in 2000, I said no mas. I shrugged. Let 'em ride some other mule.

    Now, what would happen if a whole lotta people started thinking the same way? Hey, we might just knock the last legs out from under what's left of the rapidly crumbling empire.

    Wouldn't that be awful? Boo hoo.

    Time for a big reset. Bring on the barbarians. Rome has gone to the dogs.

  5. Jimmy and Betty Killian | August 20, 2010

    The annual income at which President Obama divides the rich from the poor ($200,000.00 for individuals and $250,000.00 for families) is, in my estimation, much too high. A more reasonable divide would be 75,000.00 for individuals and $100,000.00 for families. I have worked hard all my life and never earned more than half this lesser amount. I still feel blessed and have everything I need and a few of my wants. Money management is key.

  6. Dom Brunone | August 21, 2010

    Generally a good analysis, but very incorrect at one point. Hutchinson blames the Bush administration for "playing idiotic games in not making tax cuts permanent". Unfortunately Congress had earlier passed a law, with the usual unintendended consequences, that no revenue change could be passed permanently unless the CBO could score it as being "deficit-neutral". So President Bush had no choice.

    This is precisely why President Obama and the Dems used all the smoke and mirrors and tortured analysis to wring a "deficit-neutral" score out of the CBO for its ObamaCare Bill. Without that score, Congressional rules would force it to sunset in nine years.

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