Will Congress 'Lame Walk' the '03 Tax Cuts?

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What will the tax rates be in 2011?

It has been a tough few weeks for the outgoing 111th Congress, what with the tea party throwing incumbents overboard and then giving the GOP establishment "the evil eye" on earmarks. If the Beltway crowd doesn't realize it's on double secret probation, it hasn't been paying attention.

What makes this post-election session anything but lame is the pivotal issue of tax rates for the next calendar year, which begins in only 34 days.

The current tax rates expire on Dec. 31 and, if not extended by Congress and President Barack Obama, they will jump back up to 2003 levels. If you pay taxes, this is a big deal.

A recap of what expiration would mean: The current top rate of 35 percent on earned income will rise to 39.6 percent; the rate on long term capital gains will rise from today's 15 percent to 20 percent and the top rate on dividends will rise from 15 percent to 39.6 percent. Tax rates on lower brackets will also increase.

What makes the tax code more than just a binary issue is the dynamic nature of America's style of entrepreneurial capitalism.

The U.S. economy has historically featured an array of large, small and new businesses, nurtured by a broad and vibrant capital formation eco-system from public markets to venture capital and angel investors.

The result is a dynamic and ever evolving economy, rapidly responding, innovating, disrupting and adapting in the marketplace.

This high-flux dynamism is the genesis of our economic growth and the primary reason the U.S. economy has outperformed the more statist forms of capitalism, like Japan and Germany, over the past 60 years.

It is not by chance that America's economic pie is the largest in the world. However, if we are going to meet our government's ever expanding commitments, the pie must get even bigger and keep growing for many years to come.

It is vitally important to get tax policy right because, while its primary function is to raise revenue for the government, tax policy also figures prominently in the business plans of businesses in operation as well as those still on the drawing board.

The myriad interdependencies between tax rates, capital formation, economic growth and job and wealth creation are hard to quantify, let alone to explain. Suffice it to say that higher tax rates can make funding some new ventures more difficult.

For all the angst inside the Beltway over tax rates, the reality is that federal tax revenues as a percentage of economic gross domestic product have been amazingly stable over the past 50 years averaging 18.2 percent, with modest variances - this in a half century that saw the top rate range between 90 percent and 28 percent.

The lesson is three-fold: changing rates changes the behavior of economic actors; the growth and size of federal tax revenues are closely correlated and dependent on the growth and size of GDP, and; the best policy to grow tax revenue is the one that best grows the economic pie.

Consider the past 30 years in which the top rate was cut in half, from 70 percent to 35 percent, while total federal revenues mushroomed 420 percent, from $517 billion to $2.16 trillion, and GDP went from $2.7 to $14.6 trillion.

Recently several bi-partisan efforts have offered reforms to the tax code and both recommended simpler codes with lower top rates. One of them, an interim report from President Obama's National Commission on Fiscal Responsibility and Reform (a.k.a. the Bowles-Simpson Deficit Commission) released a number of proposals including one that would eliminate all current tax deductions and "tax expenditures" and drop the top rate to only 23 percent.

Another bi-partisan task force chaired by Pete Domenici and Alice Rivlin also proposed dramatic simplification of the tax code with individual rates of 15 and 27 percent and a reduction in the corporate rate from 35 to 27 percent.

Under their plan they claim 90 million households would not have to file returns.

There is broad agreement that small business is the engine of job creation in America.

The top tax rate matters in this arena because over 4 million of the nation's small businesses, accounting for 25 percent of U.S. business receipts, are structured as subchapter S or L.L.C. corporations where business income is passed through to owners' personal returns.

Raising the top rate from 35 to 39.6 percent would be a direct drain on the working capital of the most successful of those 4-plus million businesses and would no doubt diminish some of their plans for growth and expansion.

Which brings us to the companion issue that has bedeviled both sides of the political aisle and made the Tea Party boiling mad - spending.

Spending, taxes and deficits are inextricably linked but in the search for solutions it is imperative to frame the situation and differentiate between problems and symptoms.

In today's Washington, deficits are not a problem but rather a symptom - the result of a mismatch between too much spending (Problem 1) and a shortfall in tax revenues (Problem 2) due to a sputtering economic recovery. You don't treat the symptom, you solve the problem.

Problem 1 falls to the 112th Congress. Problem 2 is best addressed by a robust and growing economy.

The current Congress can make a big step in that direction by extending the current tax rates.

The specter of government spending chewing up large chunks of municipal, state and federal tax revenues conjures up the scene from the movie Jaws where the great white shark began to devour the back end of the small trawler to which, Roy Schneider declared: "We're going to need a bigger boat."

In terms of the nation's economy and government taxing and spending: "We're going to need a bigger pie!"


Ashby M. Foote III is president of Vector Money Management in Jackson, MS. Contact him at ashby@vectormm.com.

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