2011 Taxes Remain in Limbo

In my email this morning was this message from Charles Schwab about their take on what Congress might do with tax rates:


2011 Taxes Remain in Limbo
Michael T. Townsend
Vice President, Legislative and Regulatory Affairs, Charles Schwab & Co., Inc.
September 29, 2010

Key points

  • Unless Congress takes action, most Americans will see their taxes rise next year.
  • We handicap the likely outcomes of the tax debate.
  • Helpful information for all investors and taxpayers.

Congress returned to Washington in mid-September with relatively few “must do” items on its list. But the one topping that list is a biggie: dealing with impending tax increases that could affect virtually every American.

The Bush-era tax cuts enacted in 2001 and 2003 are set to expire at the end of 2010. If Congress does not act, most Americans will see a tax increase in 2011 as income-tax rates rise, taxes on capital gains and dividends increase, and the estate tax—currently at zero—returns in a big way.

The deadline isn’t a surprise to lawmakers—it’s been looming for years. However, as the calendar turned from summer to fall, there was little indication that a solution was coming anytime soon. Congress will wait until it convenes after November’s mid-term elections in a “lame duck” session to resolve the tax conundrum.

Here’s our analysis of the likely outcomes of the tax debate, and the political hurdles that must be overcome to reach agreement.

First possibility: Congress does nothing
Odds: 10%
Under current law, all of the tax cuts are set to expire December 31, 2010, with rates reverting (in most cases) to their pre-2001 levels. The 10% bracket would disappear completely, and the other tax brackets would rise (see chart below). In addition, the per-child tax credit would fall from $1,000 to $500, and the “marriage penalty”—married couples filing jointly getting a smaller deduction than if they filed separately—would return.

Capital gains taxes would increase from 15% to 20% for all taxpayers, and dividends would be taxed as ordinary income. The estate tax, which was eliminated at the beginning of 2010, would return at a rate of up to 55% on estates valued at more than $1 million.

If Congress can’t agree on an alternative proposal, the old tax provisions would be restored on January 1, 2011. In the pre-election atmosphere, this worst-case scenario will be a popular talking point on the campaign trail, as candidates from both parties point the finger of blame at each other for possible tax increases in 2011.

Realistically, however, once the election is over, it seems highly unlikely that lawmakers will let taxes go up for nearly everyone, particularly given the economy’s continuing struggles. Serious negotiations on a compromise solution will take place shortly after the election.

And even in the unlikely event that the current Congress does nothing, expect the new Congress to act in early 2011 to implement some sort of fix that’s retroactive to the beginning of the year.

Second possibility: Congress approves President Obama’s proposal
Odds: 30%
President Barack Obama has stuck with his long-standing position of allowing taxes to go up only on individuals earning more than $200,000 and couples earning more than $250,000. Under his plan, only the top two tax brackets would increase: The 33% bracket would return to 36%, and the 35% bracket would go back to 39.6%.

In addition, the president has called for taxes on dividends and capital gains to increase from 15% to 20% for filers in those top two tax brackets only. Most filers would see the rate remain at 15%, while the lowest tax bracket would continue to have 0% tax rate on capital gains and dividends.

Finally, President Obama recommends that the estate tax be made permanent at a 45% rate on estates valued at more than $3.5 million ($7 million for couples).

Senate Democratic leaders put forward legislation that mirrors the president’s proposal in late September. However, several key Democrats have publicly expressed concern about raising taxes on anyone given current economic conditions. It doesn’t appear right now that the necessary super-majority of 60 votes in the Senate (where Democrats currently hold a 59-41 majority) is attainable. That could change after the election.

Third possibility: Congress extends all the tax cuts for one or two years
Odds: 50%
The outcome that appears most likely—though far from certain—is that Congress simply extends all of the tax cuts for one or two years. Republicans would unanimously support such a proposal, and several Democrats have signaled their support for the idea. If faced with a choice between letting the tax cuts expire and extending all of them for a year or two, most observers think Congress would choose the latter.

The big stumbling blocks are the budget deficit and an obscure rule governing budgetary items. Extending all of the tax cuts, even for just a year or two, would increase the budget deficit, which is already approaching $1.5 trillion. Many lawmakers are deeply concerned that the massive debt the United States is compiling is creating a hole that may be almost impossible to escape.

Further, under rules known as “pay as you go,” any tax cut must be offset with either spending cuts or tax increases. There are a number of exceptions, including one for income-tax rates for taxpayers with income up to $250,000 ($200,000 for single individuals).

Also, keeping the capital gains and dividends tax rate at 15% would technically require Congress to find approximately $100 billion in offsets, which seems unlikely in the current environment. Congress could just ignore the “pay-go” requirement, but some Democrats are reluctant to do so, since it was they who pushed for this new statutory requirement at the beginning of 2009.

Potential income tax rates for 2011

If Congress extends current law Obama proposal If Congress does not act
10% 10% 15%
15% 15% 15%
25% 25% 28%
28% 28% 31%
33% 36% 36%
35% 39.6% 39.6%

Fourth possibility: Some other compromise emerges
Odds: 10%
None of the three options described above yet enjoys broad support. That may change in the weeks ahead, but it also leaves the door open for another proposal to be put forward to resolve the issue.

Some lawmakers have proposed letting the estate tax return to where it was in 2001, while preserving the other tax cuts. Others have proposed dealing just with income tax rates, while allowing the capital gains rate to return to 20% for everyone and dividends to be treated as ordinary income. Other proposals could emerge. At this point, though, the three scenarios outlined above are the main players.

The final complicating factor is the election itself. Republicans are widely expected to make significant gains in both the House of Representatives and the Senate, narrowing the current large margins and possibly even taking control of one or both chambers.

While newly elected members will not take office until January, the lame-duck session looming in November and December is likely to include a number of lawmakers who have lost their seats. Freed from political repercussions, these members could vote in unpredictable ways.

There are numerous moving parts to the tax endgame, and it remains very difficult to predict the outcome. We’ll continue to provide updates as developments warrant.


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