It is possible that something will happen on Capitol Hill before the election, but it increasingly appears that if anything is to be done before tax rates rise — as the ball falls in Times Square at midnight on New Year’s Eve — it will be done in a postelection lame-duck session.
Even then, there is a potential for deadlock as Democrats, who are sure to control the White House next year, and Republicans, who hope for large gains in Congress, insist on their own solutions and argue that any failure to act is the fault of the other party.
“We’re in a big game of chicken now,” said Roberton Williams, a senior fellow at the Tax Policy Center in Washington.
There is already talk that all this could devastate financial markets and the economy, which has seemed to be slowing after a good start to the recovery earlier this year.
If it appears that nothing will be done in Washington, companies are likely to take matters into their own hands. With the tax rate on corporate dividends, now 15 percent, set to rise as high as 39.6 percent in 2011, some companies no doubt will accelerate planned 2011 dividend payments and make them before the end of 2010.
With the maximum rate on long-term capital gains set to rise to 20 percent, from 15 percent, the pressure to take capital gains this year rather than next may not be as large, but it will be present. That could lead to selling of stocks, bonds and even real estate on which investors have profits to realize.
Since the government is always willing to allow people to incur a tax liability, there are no restrictions on immediate reinvestment in the same security, as there are when a capital loss is realized. So if you want to take profits on shares that you wisely bought early last year, you can do so and then immediately repurchase the shares.
If enough companies and investors do such things, government tax revenue will be unexpectedly high for 2010, and then suffer the following year.
It seems obvious to say that higher taxes discourage economic growth and hurt investments, and that lower taxes do the opposite, but it is not as simple as that, as James Grant noted in the current issue of Grant’s Interest Rate Observer. He pointed out that taxes were raised in mid-1932 — with the top marginal tax rate rising to 63 percent, from 25 percent — on the theory that lower government deficits would increase confidence. By then the stock market, and the economy, were near their Depression lows. It was a great time to invest, if anyone had any money left.
Similarly, Republicans forecast disaster when the Democratic Congress and President Bill Clinton raised taxes in 1993, and forecast rising prosperity when taxes were cut in 2001. Both forecasts were wrong.
From the end of 1993 through the end of 2000, the American economy grew at a compound annual rate of 3.9 percent. Since then, the average rate has been 1.6 percent. The Standard & Poor’s 500-stock index rose at a compound rate of 13.1 percent a year during the first period, assuming reinvestment of dividends. Since then investors have not even broken even. Of course, there is no way to know what would have happened had tax laws not changed in those years.
It was the 2001 and 2003 tax cuts that produced the current absurd situation. But it is no credit to the Democrats that they did nothing to fix the system — and reduce uncertainty — in the last two years when they held the White House and had majorities in both the House and Senate.
In 2001, the law as passed called for income taxes to rise to their pre-2001 levels at the end of 2010. The estate tax would be phased out, and end entirely in 2010. After that, it would bounce back to 2000 rates and rules.