The Done-Nothing 111th and Taxes

WASHINGTON--As the Done-Nothing 111th Congress waddles back to Washington for its "lame-duck" session, its most pressing issue is taxes. Will Congress allow income, capital, and estate taxes to rise on January 1 as the law now contemplates, hurting the already-fragile economic recovery? Or will it pass full or partial extensions of current tax rates?

This Congress has not even passed a budget for this fiscal year, but has spent much time on health care and financial reform. The former raised the prospective cost of hiring and impeded job growth, and the latter likely has made borrowing more difficult by raising capital requirements. Congress could have created tax certainty for 2010 and the years ahead, but it has failed to do so, so far.

On Wednesday the Bipartisan Policy Center Debt Reduction Task Force proposed a year-long payroll tax holiday, spending cuts, and tax reform. Chaired by Alice Rivlin (Democrat) and Pete Domenici (Republican), it proposes a new 6% sales tax, lower income tax rates, and limits on deductions, resulting in about $2.5 trillion in tax increases over the next decade.

The chairs of President Obama's deficit reduction commission, Republican Alan Simpson and Democrat Erskine Bowles, last week proposed to raise taxes by "only" a trillion dollars over the next decade. Like Rivlin-Domenici, they would lower rates and modify or eliminate deductions for home mortgage interest, charitable contributions, and state and local income and property taxes. They would raise the federal gas tax, now 18.4 cents a gallon, by 15 cents a gallon.

Congress does not seem inclined to act on either package of recommendations during the lame-duck session.  This is fortunate, because mature, unhurried deliberation is warranted. The 111th will either extend current rates, or not, leaving major tax reform decisions to the new 112th Congress.

Time is running short. By mid-November, the Internal Revenue Service has usually given employers tax withholding tables for the next year. This year, the IRS - and employers - are in the dark, and workers don't know if they'll face smaller paychecks.

Congress in the next few weeks needs to address individual income tax rates, taxes on investment, estate taxes, the alternative minimum tax, and tax extenders. If it does nothing, all will go up.

Income tax rates. Individual income tax rates have received the most attention because they affect the largest number of people. Rates are scheduled to rise from 10% to 15% at the bottom of the income scale, and from 35% to 39.6% at the top. Because certain deductions would be disallowed for top earners, the effective top rate could be closer to 43%.

Taxes on investment. Taxes on long-term capital gains would rise from 15% to 20%, and taxes on dividends from 15% to the taxpayer's ordinary income rate. Taxpayers paying 28% on additional salary income would also pay 28% on "qualified" common stock dividends, reinstating double taxation of dividends, where income is taxed once as corporate earnings and a second time when distributed as dividends.

Estate taxes. The biggest jump in taxes in 2011 if Congress did nothing would be the estate tax, which some call the death tax. It was repealed for 2010, but it would come back in 2011 at 55% for some estates above $1 million, creating a business windfall for estate planners. Many combinations of homes and retirement accounts exceed the $1 million threshold. Some suggest reinstating the 2009 rate of 45% above an exemption of $3.5 million.

Alternative Minimum Tax. Far less well-known is the alternative minimum tax, a parallel levy adopted in 1969 because 155 high income earners were found to have paid no federal income tax. Over the past 15 years, however, the AMT - because it is not indexed for inflation, and because the nature of deductions has changed - has come to affect primarily families with large numbers of children in states with high income tax rates.

Every year since 2001 Congress has adjusted the AMT. Without an adjustment for 2010, 27 million taxpayers (about 16%), would owe additional payments averaging $3,900, according to the Congressional Budget Office. Most taxpayers earning between $100,000 and $500,000 would be affected.

Tax extenders. Most people are unaware of the vast array of small tax credits that Congress renews annually. They have not yet been renewed for 2010, let alone for 2011, and many firms were relying on being able to claim these credits this year. They include credits for research and experimentation, biodiesel and biomass fuel, clean coal; low-income housing; and exclusion of unemployment benefits from gross income.

Uncertainty about what the tax code will be for this year and next has never been so great, and is contributing to the high unemployment rate. The current Congress has abdicated its responsibility, and is truly a Done-Nothing Congress.

In its last few precious weeks, Congress should focus on making clear to the American public what tax rules and rates will be for 2010 and 2011, if not longer, so as to encourage economic activity and create jobs.

The simplest and most obvious remedy would be to extend the 2010 taxes, the "patch" for the alternative minimum tax, and the other tax extenders for two years, with the possibility of reverting back to 2009 estate tax rules at a cost of $476 billion, according to the Treasury Department.

Either this Congress or the 112th should pay for the tax extensions with spending cuts, aiming for 2008 levels, as has been proposed by House Speaker-Elect John Boehner.

Standing in the way of sensible tax reform are the budget gimmicks that Congress uses to pass tax cuts for short periods of time so as to make the longer-term cost seem lower. The first responsibility of the 112th Congress will be to put in place a better process, one conducive to transparency and timely decisions for taxes and spending cuts. Then it could be a Done-Something Congress.