Sunsets Are the Big Tax Story of 2010

The U.S. enters 2010 the way many bad movies end, by riding into the sunset.

Back in the early days of George W. Bush's administration, opponents of his tax cuts were as helpless as Republicans have been during the health-care debate. But a U.S. Senate rule named for Democrat Robert Byrd allowed Bush's opponents one seeming victory. To satisfy the Byrd rule, most of the tax cuts had to be considered temporary, so they were written to be rescinded in the then-distant year of 2010.

Welcome to the Sunset

As bad as you might have felt on New Year's Day, the goal of this column is to make you feel worse. Before reading further, you might consider grabbing the Excedrin. The list of tax provisions set to expire is long and significant.

If you are married, have kids, have income, or run a small business, your taxes are in play this year.

Bush cut income tax rates, dividend tax rates and the capital gains tax. He reduced the estate and gift taxes, expanded the earned income tax credit, reduced the marriage penalty, expanded the child tax credit and allowed small businesses to deduct a more generous share of their expenses.

Those are just the big ones. An analysis by Congress's Joint Committee on Taxation listed 113 tax provisions expiring in 2009 or 2010.

If you are married, have kids, have income or run a small business, your taxes are in play this year.

The question is, will Democrats let these sunsets happen? For some of the provisions, the crystal ball seems clear. With others, it's anybody's guess what might happen.

Campaign Pledge

First let's look at income taxes. During the campaign, President Barack Obama and most Democrats promised not to increase taxes on taxpayers with incomes below $250,000. Even though the Senate's health-care bill clearly violates that pledge, it doesn't constitute income-tax legislation in the most literal sense. It seems reasonable to expect that Democrats will otherwise try to honor Obama's $250,000 floor.

That means the expanded earned income tax credit, the more generous child credit and all of the tax-rate reductions that apply to those with incomes below $250,000 are probably safe. Indeed, extensions of those tax breaks were incorporated into Obama's long-term budget outlook last year.

If your income is above $250,000, on the other hand, horrors may await you. Major tax hikes appear inevitable, and the sunsets of 2010 are just the opening that Democrats need.

Here is the problem. Back in March, the Congressional Budget Office estimated that the tax provisions in Obama's budget would increase the deficit by about $2 trillion over 10 years. That estimate counted on revenue from so-called cap-and- trade legislation that is now widely viewed as dead.

Bill Grows

Making matters worse, the overall budget outlook has deteriorated since then. Policy changes and economic developments since March have increased the CBO's baseline deficit over the next 10 years to $7.1 trillion from $4.4 trillion. Add in the extensions of the favored tax breaks, and that number climbs to almost $10 trillion. Somebody is going to be stuck with the bill, and if your income is above $250,000, you can bet it will be you.

If the Bush tax cuts expire, then the marginal tax rate on high incomes climbs to 39.6 percent from 35 percent. My guess is that technical tricks like phasing out deductions and imposing some version of a so-called millionaire surtax and war surtax get stuck in there too, perhaps lifting the top rate to around 45 percent.

That would be very bad news for equity markets. The tax rate on dividends received by those with high incomes is also set to jump from 15 percent to whatever the top income tax rate will be. This will be the largest increase in dividend taxes in history, severely undermining income from equities.

Batting Zero

To be sure, during the campaign, Obama promised that he would lift the dividend tax only to 20 percent. Given that he is batting approximately zero for a thousand on the political promises he made to moderates, it seems unlikely that such a pleasant outcome will be achieved. By the way, the capital gains tax rate is going to go up as well, probably from 15 percent to 20 percent.

The estate tax is, as of this moment, zero. However, it seems likely that last year's rate of 45 percent, on inheritances greater than $3.5 million for an individual, will be restored, retroactive to the start of this year.

All these tax hikes are a big deal for taxpayers, political handicappers, and economic forecasters.

Be Prepared

For individuals, the best way to get ready is to load your income into 2010, before the tax rates go up. If you have capital gains, realize them. If you have a big bonus coming, don't let it wait until 2011.

Economic forecasters will have to factor the higher taxes into their calculations. It seems likely that the recovery will be threatened by them late next year.

And political handicappers should ask themselves how low the approval of the Democrats will go in this election year. American politics has never seen an attempt to follow a massive and unpopular health bill with the mother of all tax increases. Until 2010, that is.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

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