When the Tax Hikes Are Coming

The middle class will get a two-year respite, but the rich are a much easier political target.

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If you love class warfare, your moment has arrived. The next several weeks, leading up to the November elections, are sure to be filled with resounding political invective over who should pay for Washington's profligate spending over the last decade. Democrats will argue that the rich and near-rich should pony up, since they have the most money to start with. Republicans will point to the needy, arguing that they've been getting too much aid for too long. Tea Partiers will struggle to decide whose benefits should be cut in order to achieve the smaller government they envision. All around, livelihoods will be threatened. Instead of the "silly season," the midterm elections will feel like the angry season.

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It sounds very entertaining. But if you'd rather stick your fingers in your ears until November 3, feel free: For all the shouting that's on the way, it's not hard to predict what's going to happen.

Tax policy over the last 20 years has swung left and right based on the ideology of the governing party. But America can no longer afford the luxury of a manic tax code driven by what the party in power thinks is fair. Instead, simple math is now taking over. Revenue from individual income taxes, for example, was relatively stable between 1970 and 2000, ranging from about 8 to 10 percent of GDP, according to the Congressional Budget Office. After the Bush tax cuts of 2001 and 2003, that figure fell to a record low of about 7 percent. The late, great recession drove it even lower.

If federal spending had fallen by a similar amount during the last decade, President Obama might be able to extend all those tax cuts once they expire at the end of this year, and declare America Low-Tax Nation. But of course government spending has gone up and up, thanks to two overseas wars, skyrocketing Medicare and Medicaid costs, and a brutal recession that drove tax revenue down at the same time the government spent more than $1 trillion in stimulus aid. The resulting federal debt, about $14 trillion, is now as big as the entire economy. If it continues to mushroom as forecast, the debt will eventually crush us all via rising interest rates, stagnant growth, and pure shame.

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It's the job of Obama and his fellow politicians to make sure that doesn't happen, and they're thinking about getting around to it some day, maybe. Most economists feel the solution is a combination of tax increases and spending cuts, since doing one or the other alone would be too draconian to disguise with the usual opposite-speak out of Washington. The first real opportunity to do something arises this fall, since income taxes for most Americans will automatically go up unless Congress and Obama extend some of the Bush tax cuts. Here's what's likely to happen:

Wealthy taxpayers are going to pay more. Obama wants to raise the top two income brackets from the Bush-era levels, which means the top rate will rise from 35 to 39.6 percent and the rate in the next bracket will rise from 33 to 36 percent. That effectively means that taxes will rise for individuals with income over $200,000 and couples earning over $250,000 (after accounting for deductions). There will also be new limits (same as the old ones, before the Bush cuts were enacted) on the total amount of allowable deductions, which will bump a few additional people into these higher brackets. To enact these "tax hikes" on the wealthy, Congress doesn't need to do anything—it will happen automatically at the end of 2010, once the Bush tax cuts are over.

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There's a lot of "debate" about this, but for the Democrats who control Congress, the political calculus is irresistible. Those who would fall into the two higher brackets account for just 3.4 percent of all taxpayers, according to the Tax Policy Center, and those people tend to be Republicans anyway. So few Democratic votes would be at stake. And Republicans themselves have been bellyaching about how important it is to start attacking the debt. Republicans counter by arguing that enacting any tax increase in a weak economy is dangerous, because it could crimp spending just when it's needed most. There's truth to that, but the majority of evidence suggests that tax increases on the wealthy would cut into what they save, not what they spend. The media will treat this whole issue as a huge drama, but the fact that a Democratic Congress would have to pass a new law to prevent higher taxes on the wealthy weighs heavily in favor of a tax increase. Call your accountant.

The middle class will get a temporary pass, but it will only defer the inevitable pain. Obama has pledged no new taxes on the middle class, and no matter how implausible that is, it's hard to see him breaking that promise in his first term. Besides, raising the income tax rates on the majority of taxpayers would be risky in a lousy economy, so the odds are high that Congress will extend the Bush tax cuts for those who fall below the $200,000/$250,000 thresholds. The Senate, which moves slower than the House, may not get to that before the November elections, so the action may come in the lame-duck session that follows, leading to plenty of high-volume gamesmanship right up until the elections. But not much will change for the majority of taxpayers.

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The respite, however, will be short-lived. One reasonable guess is that the Bush cuts will be extended by only two years, forcing Washington to deal with them again in 2012—when the economy, presumably, will be stronger. At that point or soon after, Congress will have to get serious about new taxes—and there aren't nearly enough wealthy Americans to finance a solution, at any tax rate. "We've been selling government services at 80 to 90 percent of their cost," says Clint Stretch, managing principal for tax policy at Deloitte Tax. "We're going to have to start selling them at a premium to pay for the discounts in the past."

Possibilities include not just higher tax rates on those who already pay, but a host of scaled-back deductions—including the mortgage-interest deduction for home purchases—and a new value-added tax that could raise the cost of most goods and services. Exemptions for lower-income workers could be narrowed as well, so more people pay taxes. The tumult will be fascinating, since voters are likely to revolt no matter how bankrupt American becomes or what is fiscally prudent. But for now, politicians are looking the other way.

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The "making work pay" credit has a good chance of being extended for one more year, through 2011. This was part of the 2009 stimulus plan that reduced the tax burden for individuals by $400 and for couples by $800, up to income thresholds of $95,000 and $195,000. It was initially put into effect for 2009 and 2010; Obama wants to extend it through 2011, and he'll probably get his wish. The tax credit benefits about three-quarters of all taxpayers, and can plausibly be counted as additional "stimulus" that will help the economy recover. So it has popular appeal despite an estimated cost of about $60 billion in lost government revenue for each year it's in effect. It wouldn't be surprising if Obama pushed to extend this into 2012 as well, to claim credit for middle-class tax cuts in an election year.

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Estate taxes have nowhere to go but up, especially since they were cut to nothing at all for 2010. There are two basic issues: What the tax rate should be, and what portion of an estate should be exempt from taxes before the government takes its share. Most proposals are coalescing around an exemption of between $3.5 million and $5 million, and tax rates that range from 35 to 50 percent after that. Conservatives loathe the "death" tax, complaining that it's a second levy on money's that already been taxed once. But unbeknownst to them, lean times have turned public opinion squarely against the super-rich, who are the only ones really affected by estate taxes. After the 2010 holiday, a reinstatement seems inevitable.

The real battle over higher taxes and lower spending will probably kick off following the 2012 elections. "The choices are all very, very ugly," says Stretch. The first part of any serious effort would probably be sharp spending cutbacks, which have to affect Social Security and Medicare recipients if they're going to be meaningful, since that's where much of the money goes. When that produces howls of outrage, lawmakers will turn to widespread tax hikes to spread the pain around. But new taxes are never popular, and the rancor could push a solution even further into the future. Compared with that, this year's elections might seem downright cheerful.