Taxes No Longer So Certain

Death may still be certain, but taxes have never been less so.

United States taxes may soar next year, or they may not. The estates of some very wealthy people who die this year may save hundreds of millions in taxes, but those of merely wealthy people may leave their heirs in much worse shape than if the person had died last year. Or Congress could try to retroactively change that.

Taxes on corporate dividends are in line to soar next year, while those on long-term capital gains will rise, but less abruptly. Virtually everyone will pay higher income taxes if the law is not changed.

The current situation is absurd, a monument to George W. Bush’s determination to cut taxes by the maximum amount possible and to Congressional unwillingness to compromise either in 2001 or now.

Virtually no one, save for Alan Greenspan, a former chairman of the Federal Reserve, thinks it would be a good idea to let current law stand. Mr. Greenspan says he is worried about budget deficits, while other economists are worried about choking off growth.

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.

Where is the logic in all the tax talk?

That was not done because anyone thought it would be good tax policy to raise rates in 2011. Instead, under an obscure Senate rule, it was possible to pass such a bill with fewer votes than would be required for a permanent cut. In addition, the 10-year math used in budget calculations looked better if it could be assumed that tax rates would rise in 2011.

Such arithmetic alchemy was not really needed then. Democrats were not determined to block any tax cut, and enough votes to meet the Senate rule could have been found with a permanent tax cut that was smaller, but not necessarily a lot smaller, than the one that was adopted.

But Republicans were in no mood to compromise that much if they did not have to, and Mr. Greenspan’s statements at the time were typically Delphic but seemed to support the cuts.

Budget forecasts at the time were for surpluses, even with lower taxes. It turned out those predictions were based on bad assumptions about tax receipts, in part because of a lack of understanding about the extent to which the 1990s stock market boom had inflated tax revenue. Spending forecasts did not assume that two long wars were about to be fought.

Now forecasts are for huge deficits. Those forecasts could be similarly wrong if the economy is able to return to stronger growth. The chances of that happening do not, however, seem to be increased by raising everybody’s taxes just now.

When the Bush tax laws were passed, there were jokes about the “Dr. Kevorkian provision,” named for a doctor then notorious for assisting patients in committing suicide. The idea was that as the final days of 2010 approached, the children and grandchildren of superwealthy people would be encouraging them to go quickly to save on taxes.

Those were jokes then. Even a year ago, few thought Congress would fail to act long before now.

In 2009, there was estate tax only on estates over $3.5 million. And that figure covered the value of estates after deducting bequests to spouses and charitable contributions. Next year, if current law holds, the exemption will fall to $1 million. Amounts over that, not including the charitable contributions and spousal bequests, will be taxed at rates up to 55 percent, compared to 45 percent in 2009.

Some still think Congress could retroactively change the estate tax law for 2010. If it did so, the action would certainly be challenged in court.

Repealing the estate tax was not good news for some estates of people who died in 2010. That is because the repeal also limited the step-up in tax basis for inherited property.

Until 2009, and next year as well if current law remains in effect, any property passed on to heirs gets a tax basis based on value at the time of death, not original cost. But this year, estates can step up value only on $1 million of assets that are left to someone other than a spouse.

The result is that heirs to estates with more than $1 million of taxable bequests, but not a lot more than $3.5 million, are likely to end up worse off this year than they would have if the person had died in 2009.

Getting the data on original cost will not be easy for some heirs. If your father died this year and left you 10,000 shares of I.B.M. stock, and those shares were not part of the $1 million in assets whose value was stepped up, then your tax basis is what he paid. Any sale by you will produce a large — and taxable — capital gain.

As to whether those shares are included in the $1 million, it is up to the estate executor to determine which assets are stepped-up in basis. That could lead to hard feelings, not to mention lawsuits, among heirs.

For the ordinary income tax, marginal tax rates now range from 10 to 35 percent. If nothing is done, they will revert to a range of 28 to 39.6 percent. The Tax Policy Center estimates that effective tax rates would rise for all income groups, with the largest increase on those with the highest incomes.

President Obama wants to return the estate tax to 2009 levels, and renew the tax cuts for all but the highest-income taxpayers. He wants to tax both dividends and long-term capital gains at 20 percent rates.

Most Congressional Republicans want to renew all the tax cuts, although some would be willing to reinstate estate taxes. There has been talk of extending income tax cuts for two or three years, setting up another potential battle then.

Congressional partisanship and hesitation to compromise across party lines seemed high in 2001. Now there is much less willingness to compromise. Logically, the parties should at least be able to pass the cuts — from planned 2011 levels — that virtually everyone agrees are wise.

But there is no guarantee that such logic will prevail.