The Crunch Is Coming on Taxes

08/19/2010 11:00 am EST

Focus: MARKETS

Knight Kiplinger

Editor-in-Chief, The Kiplinger Letter, Kiplinger's Personal Finance, and Kiplinger.com

Knight Kiplinger, editor-in-chief of The Kiplinger Letter, says there’s a tough battle ahead over whether to extend the Bush tax cuts, and he predicts what will happen.

Caught between a rock and a hard place—that’s where lawmakers are on taxes.

The decision whether to extend the Bush tax cuts, due to expire at year-end, is fraught with danger.

Our judgment: a one-year extension—but not for upper incomers. Their rates would return to 39.6% from 35% now. On dividends and capital gains, they’d pay 20%, up from 15% now.

Here’s why that’s the most likely option.

Letting all rates rise hurts the economy, shaving at least six-tenths of a percentage point off gross domestic product (GDP) gains in 2011 and crimping job creation.

Considering the still-wobbly state of the economy, that’s a hit [President] Obama and Congress won’t want to take. Because wealthier taxpayers spend a smaller share of their income, the economic sting is much less if they alone lose the benefit of today’s lower rates.

Extending all the cuts drives up the deficit. If all taxpayers get to hold on to the Bush rate cuts, [there will be] an additional $3 trillion in budget deficits by 2020 and public debt at 82% of GDP, up from 60% now.

Even President Obama’s proposal would be costly. Permanently keeping lower rates—if only for individuals with taxable incomes under $200,000 a year and for couples under $250,000—would pile an additional $2.3 trillion onto the national debt.

Plus, a short-term, partial extension plays out better for the Democrats, and it’s what that party’s leaders in the House and Senate hope to arrange as the only option voted on.

That’d put Republicans, who want to extend the cuts to all taxpayers, in an awkward position: Vote yes on holding down the tax rates only for middle and lower incomers or be painted as favoring higher taxes for all.

But here’s why that option is iffy. Even a temporary partial extension costs. Deficit hawks will balk, pointing to Europe’s recent woes as an object lesson in the need for US policymakers to impose fiscal austerity sooner, rather than later.

[And] Republicans may hold out for an extension for all taxpayers. Among their arguments: Raising taxes on high incomers punishes small businesses. So, lawmakers may duck, putting off the tough decision until next year. That would keep the lower Bush-era tax rates in force at least through 2011.

There’s no such punt possible on estate taxes, though. Even liberals don’t want to see the top rate soar to 55%, with the $1-million exemption returning. Odds of resurrecting 2009 rules for 2010 estates get shakier as time passes.

Those estates may get a choice: Use 2009’s $3.5-million exemption and 45% top rate or enjoy no estate tax this year but be stuck with carryover basis rules. Then, starting in 2011, a phase-in of lower rates and higher exemptions.

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