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Largest Tax Increase in US History

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
July 13, 2010

IN THIS ISSUE:

1.  Bush Tax Cuts to Expire Automatically

2.  Large Income Tax Hike for the “Rich”

3.  Small Businesses are the Engine of Jobs Growth

4.  The Rich & the “Fair Share” Argument

5.  Will Congress Extend the Bush Tax Cuts or Not?

6.  Results of our recent FINANCIAL LITERACY QUIZ

Introduction

Last week, I pointed out that the Consumer Confidence Index plunged in June when economists had expected it to hold steady.  Most of the other economic reports I quoted last week were also negative.  So why the sudden change in mood?  A major reason for the revival of sour economic news is the looming expiration of George W. Bush’s tax cuts.  

Unless something changes, Americans are facing the largest tax increase in history at the end of this year.  Sadly, no members of Congress will have to vote on this massive tax increase, and President Obama will not have to sign it – it will happen automatically.  It happens at midnight on December 31, 2010 when the tax cuts expire – unless both houses of Congress vote to extend all or part of them and Obama signs it into law.

President Obama has promised that he would extend the Bush tax cuts for those individuals making less than $200,000 and couples making less than $250,000.  The problem is that Congress still has to vote in both the House and the Senate to extend the tax cuts for those in the middle and lower tax brackets. 

With the deficit running out of control, more than a few Democrats are balking at extending the Bush tax cuts for all but the “wealthy.”  The legislation to extend the tax cuts is mired in committees, and will not likely be passed this summer.  Some Democrats want to wait until after the November elections, when the time to extend them will be short.  It is no wonder then that so many taxpayers are becoming increasingly concerned.

This week, we will revisit the issue of the Bush tax cuts expiring, or not, and update you on other tax benefits that will be lost or reduced at the end of this year.  This is especially important for those of us with capital gains and/or stock dividends.  While I don’t realistically expect all of the tax cuts to expire, it will be interesting to see how Democrats reconcile their stated desire to control deficits and Obama’s promise to shield the middle and lower classes from tax increases.

At the end of this E-Letter, I show the test results from our recent Financial Literacy Quiz.  Over 6,000 people took the quiz!  And most of you did very well.  You can see the actual results on the last page below.

Bush Tax Cuts to Expire Automatically

Back in 2001 when the Republicans controlled Congress, President Bush was successful in pushing through major reductions in income tax rates, capital gains and dividends tax rates, increased tax credits and many other favorable tax provisions.  The Democrats couldn’t do anything to stop it, but they did invoke the so-called “Byrd Rule” which forced the Republicans to agree to a time limit for the new tax cuts.  Thus, the year 2010 was selected as the time the tax cuts would expire, or “sunset,” automatically – unless extended by Congress.

In 2001 and 2003, President 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 that were to expire 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 the Bush tax cuts expire?  Most analysts agree that Obama will be able to strong-arm the Democrats into extending the Bush tax cuts for those making under $200,000/$250,000 but as noted above, that is not a sure thing. Then there are all of the other considerations such as dividends, capital gains, estate and gift taxes, just to name a few.

Large Income Tax Hike for the “Rich”

Starting on January 1, 2011 the top marginal income-tax rate is set to increase to 39.6% from 35%.  The phase-out of itemized deductions will lift that upper tax rate, effectively, to 40.8%.  As a reminder now that ObamaCare has passed, there will be a 3.8% healthcare tax starting in 2013, thus making the top rate 44.6%.

These rates do not include the so-called “millionaire surtax” or the “war surtax,” both of which have been discussed off and on for over a year now and would only apply to the wealthy.  Should either of these onerous taxes be added on, we could see the top tax rate approaching 50% in 2013.

President Obama has proposed that, when the Bush tax cuts expire, the tax rate on stock dividends and capital gains will go from 15% currently to 20% on January 1.  But he has also said that these taxes could be raised to as high as 28%.  While I don’t expect we’ll see 28% next year, it may be coming in subsequent years.  And keep in mind that if nothing is done and tax rates revert to previous levels, dividends could be taxed at the highest personal bracket of 39.6%. 

If history is any indicator, the increase in the capital gains tax rate will likely result in lower capital gains tax revenue.  Studies over the years have documented that capital gains tax revenues actually fell after an increase in the tax rates brought about by the Tax Reform Act of 1986.  However, capital gains tax revenues increased in the years following Bill Clinton signing legislation reducing the rate to 20% in 1997, and again under the Bush tax cuts that lowered the capital gains tax rate down to its current 15% level in 2003.

The reason tax revenues can vary so much is that capital gains taxes are paid only when appreciated assets held more than one year are sold and the gains are realized.  Investors often time the decision of whether or not to hold appreciated investments based on the prevailing income tax rates.  Thus, if Obama is successful in increasing the capital gains tax rate, revenues may actually fall in the short-term.

A Wall Street Journal article earlier this year noted that IRS statistical data from 2007 (latest available) show that 58% of overall capital gains revenue was reported by taxpayers with adjusted gross incomes of over $1 million.  As a general rule, wealthy individuals such as these do not need to sell appreciated assets to live on, so it’s entirely possible that they might hold onto appreciated property to see if tax rates go down in the future.

The overarching problem with all these increased taxes on the “rich” is that they don’t make a big dent in the deficits, which shouldn’t come as a surprise with trillion-dollar deficits every year.  In addition, many wealthy individuals enjoy an advantage called the “elasticity of taxable income.”  In other words, many wealthy individuals can choose how and when they take their income, usually basing such decisions on the various levels of taxation associated with each.

While most of us think of income as wages, commissions or self-employment income, many wealthy individuals have additional options available to them such as stock options, deferred compensation and others that allow them to select the timing and composition of their income.  The result almost always is that a large number of wealthy individuals shift to alternative forms of income in an attempt to mute the effects of any tax increases.

In addition to the tax hikes noted above, the estate tax – which is currently zero – is slated to return to the of 55% tax on inheritances above $1 million beginning in 2011.  While it’s easy for many voters not to have any sympathy for those inheriting more than a million dollars, we should keep in mind that the 55% that goes to the government could be used by the beneficiaries to start new businesses and create more jobs.  Sadly, some beneficiaries who inherit businesses will have to sell them to pay the estate taxes when they kick back in next year.

Soaking the Rich is a Job Killer   

According to the IRS Statistics of Income Bulletin, two-thirds of small business profits are earned in households making more than $250,000 per year. Think about that.  Most small businesses (firms with 99 or fewer employees) pay income taxes at the household level.  This means that the Obama plan to raise tax rates is a direct tax hike on most small businesses – sole proprietorships, partnerships, S-corporations, family farms, etc. – on those making $200,000 (individuals) and $250,000 (joint filers). 

According to the Commerce Department and the Census Bureau, there were more than 29 million small businesses in America in 2008, and these businesses gave paychecks to over 120 million employees.  These numbers should be even higher when we see the results of the 2010 census survey.

Obviously, small business profits are used to create jobs and invest in America.  When Obama campaigned for the presidency, he claimed that his tax hikes on those earning $200,000/$250,000 would have little effect on most small businesses.  Obviously, he had not done his homework, since the bulk of small business owners will see their tax rate increase to 39.6% (40.8% if you consider the phase-out of itemized deductions) in 2011.

Clearly, this tax increase will negatively affect most small businesses.  In fact, it already has.  According to the latest ADP National Employment Report, goods-producing small businesses with less than 50 employees have reduced their total payroll employment by about 20,000 jobs each month this year, including in June.

Why are small businesses battening down the hatches? In May, the National Federation of Independent Business asked small business owners about the most important problem they face. As usual, sales performance was the top worry, cited by 30%, unchanged from the prior year.  But 22% named taxes as their second highest concern, up from 19% a year earlier.

Small Businesses are the Engine of Jobs Growth

Small businesses create more jobs than any other sector of the economy.  Consider the following statistics from the Commerce Department and the Census Bureau.  Small firms with fewer than 500 employees:

  • Represent 99.7% of all employer firms.
  • Employ just over half of all private sector employees.
  • Pay 44% of total U.S. private payroll.
  • Have generated 64% of net new jobs over the past 15 years.
  • Create more than half of the nonfarm private gross domes­tic product (GDP).
  • Hire 40% of high tech workers (such as scientists, engineers, and computer programmers).
  • Are 52% home-based and 2% franchises.
  • Made up 97.3% of all identified exporters and pro­duced 30.2% of the known export value in FY 2007.
  • Produce 13 times more patents per employee than large patenting firms; these patents are twice as likely as large firm patents to be among the one percent most cited.

As an aside, the Commerce Dept. and the Census Bureau report that seven out of 10 new small businesses last at least two years, and about half survive five years. More specifically, according to the most recent Census data, 69% of new businesses established in 2000 survived at least two years, and 51% survived five or more years.  These survival rates for small business start-ups are considerably better than they were 20-30 years ago.

The Rich & the “Fair Share” Argument

Whenever there is talk of raising taxes on the “rich” – in this case, those individuals making $200,000 and couples making $250,000 or more per year – there are always those who argue that the wealthy are not paying their “fair share.”  And in the recent tax raising environment, we had then-candidate Barack Obama telling Joe the Plumber that the rich make too much, and we need to “spread the wealth around.”

I have reproduced below a chart that I have mentioned many times in my writings.  It is based on IRS income tax data from 2007 (latest available) and shows the percentage of income taxes paid by various demographic groups based on adjusted gross income:

Summary of Federal Individual Income Tax Data, 2007

Notice that the top 1% of income earners - adjusted gross income of more than $410,096 - pay over 40% of all income taxes paid.  How is 40% not their fair share?  Next notice that the top 25% pay over 86% of all income taxes paid.  Notice further that the top 50% of taxpayers pay over 97% of all income taxes.  Yet liberals believe they should pay even more.  

Compare those percentages with the bottom 50% of taxpayers who pay less than 3% of all income taxes.  Actually, the term “taxpayers” is probably a misnomer, since separate data from the IRS show that, of the 141 million-plus tax returns filed in 2007, approximately 47 million either owed no tax or actually received refundable tax credits that resulted in a negative tax rate.

If the top 50% of taxpayers are responsible for paying over 97% of all income taxes, I find it hard to imagine what their “fair share” should be if this isn’t sufficient.  Moreover, the top 1% of taxpayers pay a higher percentage of income taxes (40.42%) than the bottom 95% (39.37%).  How big does this discrepancy need to get before it is fair?

In the past, some have responded to this information by saying that those in lower income brackets pay Social Security and Medicare taxes, which (they say) unfairly loads the cost of that program on the backs of lower-paid taxpayers.  The problem with this argument is that it compares apples and oranges. 

Income tax revenues are designed to fund the functions of government, while payroll tax revenues were originally designed to build a “safety net” retirement payment.  Unlike income taxes that you never see again, the retirement benefits of Social Security and Medicare more than offset what most people pay in payroll taxes.

Will Congress Extend the Bush Tax Cuts or Not?

As I have noted throughout this E-Letter, all of the Bush tax cuts expire, by law, at the end of this year for everyone.  President Obama has called on Congress to pass new legislation that would extend the Bush tax cuts for everyone making less than $200,000/$250,000 a year.  Thus far, neither the House nor the Senate has managed to get this legislation out of committee.

You would think that the Democrats in Congress – with large majorities in both houses – would jump at the chance to give most Americans a tax cut (i.e. – not let the Bush tax cuts expire) going into a difficult mid-term election in November.  Yet the legislation to extend the Bush tax cuts for all but the rich is stalled in Congress.  Apparently, they do not have the votes.

There actually are a number of Democrats in Congress who have looked at the numbers and realize that extending the Bush tax cuts for all but the rich will cost an estimated $2.2 trillion over the next decade, while the increased taxes on the wealthy will only generate some $600-$700 billion in new tax revenues over the same period, according to the CBO.  There are some Democrats who are genuinely worried about increasing the deficits.

This explains why the talk in Washington is that there won’t be a vote on extending the Bush tax cuts until after the November election – even though many (but not enough) in Congress would love nothing better than to be able to go home and tell their constituents that they saved them from a big tax hike in 2011.

The thinking among Democratic congressional leaders apparently is that they will be able to garner enough votes to extend the Bush tax cuts for all but the rich after the mid-term elections, when so many Dems will likely have been voted out of office.  I’m not making this up! 

The thinking is, with so many “lame duck” members of Congress after the November election – for whom it doesn’t matter how they vote any more – that Harry Reid and Nancy Pelosi will then be able to get the votes they need to extend the Bush tax cuts for all but the rich.  But it’s certainly not a sure thing.

In the first place, passing new legislation to extend the Bush tax cuts is complicated and Congress won’t have much time to do so if they wait until after the November election.  Secondly, I think we could all agree that giving most Americans a tax cut is not a high priority for Harry Reid and Nancy Pelosi.  They are simply pushing for it because Obama wants it.

If Harry Reid is not re-elected to the Senate, I’m not sure he would continue to push for extending the Bush tax cuts.  The same could be true for Nancy Pelosi if the Republicans win a majority in the House.  The point is, extending the Bush tax cuts is not a “done deal.”

I want to go on the record and predict that if the Bush tax cuts are extended for all but the rich, they will only be extended for one year.  While it will be very interesting to see how this plays out later this year, just keep in mind that we’ll probably be facing the same tax issues a year from now.

Finally, for those few readers who always complain whenever I write anything political, I’m afraid all I can say is to get used to it.  Most readers of this E-Letter are investors who recognize that higher taxes affect not only our pocketbooks, but also the investment markets.  For them, this information is very useful.  I’m sure I will have more to say about extending, or not extending, the Bush tax cuts on all but the rich in the weeks and months ahead.

Financial Literacy Quiz Update

My recent E-Letter article on the state of financial literacy (or lack thereof) among Americans was a big hitOver 6,000 people took the test!  I received lots of positive feedback about this article, including indications that many of you took the test and forwarded it on to your friends and relatives.  Just as I had suspected, my readers tended to do quite well on the test, as did their adult children and grandchildren.

Before going into a summary of the test results, I wanted to comment on some questions and critiques we received on the quiz.  First, some of you had problems with the way the questions were worded.  Frankly, so did we.  However, for the sake of accuracy we reproduced the questions exactly as they appeared in Dr. Annamaria Lusardi’s work, so the wording is hers, not ours.

Perhaps the most contested question based on your feedback was the one about whether a single stock or a mutual fund was the most risky.  Some readers noted, quite correctly, that certain individual stocks may involve far less risk than some kinds of mutual funds on the market today.  For example, an individual blue chip stock will likely be far less risky than a leveraged Nasdaq 100 Index mutual fund.

Obviously, we don’t disagree with the notion that some individual stocks are less risky than some mutual funds.  However, this is yet another place where different wording might have prevented the confusion.  Had the question started, “In general…,” I think everyone would have understood that the question assumes similar asset classes, such as a blue chip stock versus a blue chip stock mutual fund.  So, if this was the only question you missed, go ahead and give yourself a perfect score since, technically, either answer could have been right.

Actually, I was delighted to read these critiques because it was an indication that our readers had their thinking caps on when reviewing the material.  I would much rather have analytical readers than those who may just accept anything printed in this E-Letter (or anywhere else) as the gospel truth.

As for the results, the following table provides a detailed summary of everyone who took the test and how they did:

Total number of readers who took the financial literacy quiz: 6,345
Number and percent who got all answers correct: 4,225 (66.6%)
Number and percent who missed only one question: 1,692 (26.7%)
Number and percent who missed two questions: 296 (4.7%)
Number and percent who missed three questions: 75 (1.2%)
Number and percent who missed four questions: 17 (< 0.5%)
Number and percent who missed five questions: 14 (< 0.5%)

I was very pleased to see that my readers did so well, with apprx. 93% either answering all questions correctly or missing just one question.  It was even more encouraging to read the feedback e-mails where readers told me how well their children and grandchildren did on the test.  This seems to affirm that financially literate adults can be effective in passing this knowledge on to their kids.  For those of you with young children, it’s never too early to start teaching basic financial awareness.

It was also very gratifying to read how many of those who did well on the test credited their knowledge to reading this and other E-Letters.  Even so, it is still very discouraging to know that the majority of Americans couldn’t answer these very basic questions correctly in Dr. Lusardi’s studies.

I welcome your participation in this process through forwarding my weekly E-Letters on to others you feel may benefit from them and suggesting that they subscribe.  Together, perhaps we can help make a small dent in the number of financially illiterate voters.  Just in case you missed my article on the Financial Literacy Quiz, go to my June 22 E-Letter.

Wishing you all a great summer,

Gary D. Halbert

SPECIAL ARTICLES:

Democrats likely to wait until after the election on tax changes
http://thehill.com/homenews/senate/106619-dems-to-punt-on-taxes

The Bush Tax Cuts and the Deficit Myth (good read)
http://online.wsj.com/article/SB10001424052748704738404575347302831199046.html?mod=WSJ_Opinion_LEADTop

Here’s How You Quickly Create Jobs
http://www.realclearmarkets.com/articles/2010/07/12/heres_how_you_quickly_create_jobs_98566.html


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