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Democrats face election-year tax dilemma

Will you be toasting to low taxes in 2011? Or drowning your sorrows, knowing that you’re about to get hit with ? Sometime before New Year’s Eve, Congress will need to answer those questions
Image: President Obama and Sen. Max Baucus (D-MT)
President Obama and Senate Finance Committee chairman Max Baucus face big tax decisions before year's end.Mark Wilson / Getty Images file

Will you be toasting to low taxes in 2011? Or drowning your sorrows, knowing that you’re about to get hit with a higher bill from Uncle Sam?

Sometime before New Year’s Eve, Congress will need to answer those questions. That’s because many provisions of the 2001 tax law, which lowered income tax rates, expire on Dec. 31.

Unless Congress acts to extend at least part of the 2001 law, a family of four, with two earners, making $85,000 a year, would pay about $1,800 more in federal income taxes in 2011, according to an analysis by the Tax Foundation, a nonpartisan research group which favors low tax rates and a broad tax base.

It isn’t just tax rates that are set to change in January: families with children under age 17, in particular, would stand to lose because the child tax credit would be chopped in half, from $1,000 per child to $500.

And people with taxable estates worth more than $1 million face up to a 55 percent estate tax if they die in 2011. Those dying this year face no estate tax at all.

Congress must also deal with the alternative minimum tax (AMT) which hits upper-middle income taxpayers, especially in states such as California with high state income taxes.

A pivotal moment in tax history
“The expiration of the 2001 and 2003 tax cuts is the most significant event in tax policy in generations,” said Scott Hodge, president of the Tax Foundation. “I’m hard pressed to think of another moment in the history of the tax code in which we have had so many provisions expire at the same time impacting so many Americans all at once.”

President Obama has proposed higher tax rates, 36 percent and 39.6 percent, on married couples filing jointly with incomes of more than $250,000 and on individuals with incomes above $200,000. He would leave in place the lower rates for people with incomes less than $250,000.

That would come on top of the $210 billion tax hike on upper-income people that is part of the new health care law.

But a key Senate Democrat broke with Obama Wednesday. Reuters reported that Senate Budget Committee Chairman Kent Conrad, D-N.D., advocated extending all of the tax rates that expire on Dec. 31, including the ones for upper-income people. "The general rule of thumb would be you'd not want to do tax changes, tax increases ... until the recovery is on more solid ground," Conrad said.

Senate Finance Committee Chairman Max Baucus, D-Mont., who helped pilot the 2001 tax cuts to Senate passage, is meeting this week with members from both parties to discuss the tax agenda for the rest of the year.

“With today's budget picture, it's no longer clear that we can afford large tax cuts for the most well-to-do,” Baucus told a hearing last week.

Yet it’s far from certain whether Democratic leaders can muster the votes to pass Obama’s proposal.

“It would not shock me that they would not be able to get their act together” to extend some of the 2001 tax rates, said veteran tax lawyer and lobbyist Ken Kies, who formerly served as the chief of staff to the Congressional Joint Committee on Taxation.

“Between now and Nov. 2 (Election Day), I don’t think that anything gets done,” Kies said.

So far the tax issue, overshadowed by deficits, debt, and unemployment, hasn’t been playing a dominant role in 2010 campaigns.

In the most recent NBC News/Wall Street Journal poll last month, Republicans picked deficit reduction as their chief reason for voting for GOP congressional candidates; “to keep taxes down” ranked only third among their priorities.

But in some races, Republicans are firing at Democratic incumbents on the tax question: in Washington , Republican Senate candidate Dino Rossi has called on three-term Democrat Sen. Patty Murray to block any increase in tax rates. “Washington families are struggling to find work and pay their bills, and the last thing they need is to get slammed by a huge tax increase,” said Rossi.

Murray supports tax cuts for middle-class people, "but she doesn't support extending the unpaid-for Bush tax cuts for the rich that continue to add to our deficit and don't help the middle class," said her campaign spokeswoman Alex Glass.

The Cook Political Report r ates the Murray race a toss up.  

Action in a lame-duck Congress?
If current projections prove accurate, Kies said, the Democrats will lose so many House and Senate seats that from the day after the election to Dec. 31 they're likely to react as people do after a close relative dies. “Denial, then anger, then blame — and the blame part will probably go on the longest. And that’s a hard environment in which to get decisions made.”

“My crystal ball is broken because I fully expected Congress to act last year to prevent the sun setting of the estate tax this year,” Hodge said. Congress didn’t do that. “It is looking very unlikely that Congress will be able to resolve these issues before they head home to campaign.”

He added, “I think there are some on Capitol Hill who believe taxes should be raised, for the deficit or for ideological reasons, and would prefer to have all of the tax cuts expire with none of their fingerprints on the tax increase.”

Len Burman, a respected tax policy wonk who served as a Treasury Department official in the Clinton administration, told Baucus’s committee last week that “it is a good idea to extend most of the expiring tax cuts,” but not the ones for upper-income people. He said, “I think there would be relatively little cost to letting the high-end tax cuts sunset as scheduled.”

Raising taxes on upper-income people would seem in accord with traditional Democratic principles, so why isn't this a done deal?

Because businesses would pay some of that increase, and that might inhibit hiring at a time when the economy is fragile. One indicator of that fragility: income tax revenues are down 4.4 percent so far this fiscal year, after a stunning 20 percent drop in FY 2009.

In a report issued last week, the non-partisan staff of the Joint Congressional Committee on Taxation said that $500 billion of business income would be taxed at Obama’s proposed higher rates next year if Congress enacts them. Many firms don't incorporate and thus pay at income tax rates rather than the corporate tax rate.

With 60 votes in the Senate needed to pass legislation and five Democratic senators now in toss-up re-election races, according to the Cook Political Report, a vote to increase taxes on such businesses is risky.

Is doing nothing an option?
But doing nothing is not an appealing option.

Burman told senators that simply allowing the 2001 rates to expire — thus in effect raising taxes on almost all earners — “would certainly have a negative effect. It would reduce consumption and could very well prolong the recession.”

The 2001 rates were signed into law by President Bush, but passed with Baucus and 11 other Senate Democrats voting for them.

Much has changed since 2001 when federal debt amounted to only 32 percent of gross domestic product. This year debt will hit 62 percent of GDP, the highest level since shortly after World War II, creating dramatic tension between debt reduction and tax cuts.

“Deficit concerns have become significantly greater than at any time I can remember,” said Kies, who has worked in Washington for 30 years. “As a result, a one-year extension of the Bush cuts for taxpayers below $250,000 plus two years of AMT relief, which would cost $270 billion, is not a pretty picture.”

Some analysts say deficit reduction requires tax increases, beginning next year, and eventually on not just the highest earners, but on middle-income people as well.

“If we just raised the top two rates and we wanted to get the deficit down to two percent of GDP between 2015 and 2019, the top rate would have to increase to 91 percent,” Burman told the House Ways and Means Committee last March. “We're not going to be able to solve the problem by raising rates just on the rich.”

Perhaps the most important questions for Democratic leaders are: Who pays the higher taxes, who votes in November, and how much overlap is there between those two groups?

Americans over age 55 vote in far higher percentages than younger people, especially in mid-term elections. And older Americans will be hit by a specific tax increase next year, unless Congress averts it.

“An under-reported story is the economic havoc that will occur if the tax on dividends increases from 15 percent to 36 percent (for those earning less than $250,000) and 39.6 percent (for those earning more than $250,000),” said Paul Caron, who publishes the TaxProf blog and teaches tax law at the University of Cincinnati law school.

“Many Americans, not just the wealthy, receive dividends, such as through mutual funds,” he said.

Hodge points to Internal Revenue Service data showing that taxpayers over age 55 account for 71 percent of all dividend income earned. That’s yet another reason to keep your eye on older voters as Election Day draws closer.