Our Forecast for Bush Tax Cuts in 2011: A Hit on the Wealthy

Lawmakers are caught between a rock and a hard place on taxes. The decision whether to extend the Bush tax cuts -- passed in 2001 and 2003 and due to expire at year-end -- is fraught with danger.

Our current judgment: a one-year extension of the Bush tax cuts, but not for upper incomers, individuals with taxable incomes over $200,000 a year and for couples with annual incomes of more than $250,000. Their rates would return to 39.6% from 35% now, and on dividends and capital gains, they’d pay 20%, up from 15% now.

Here’s why that’s the most likely option -- or at least why other options have even less appeal.

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• Letting all rates rise hurts the economy, shaving at least six-tenths of a percentage point off GDP gains in 2011 and crimping job creation. Considering the still-wobbly state of the economy, that’s a hit Obama and Congress won’t want to take. Because wealthier taxpayers spend a smaller share of their income, the economic sting is much less if they alone lose the benefit of today’s lower rates.

• Extending all the cuts drives up the deficit. Letting all taxpayers hold on to the Bush rate cuts would add $3 trillion to Uncle Sam’s annual budget deficits by 2020. Total public debt would hit a whopping 82% of GDP by then, up from 60% now. The fact is, even Obama’s more-modest proposal would be costly. Permanently keeping the lower rates -- for all but the highest earners -- would pile an additional $2.3 trillion onto the national debt.

• Plus, a short-term, partial extension plays out better for the Democrats. In fact, that’s what that party’s leaders in the House and Senate hope to arrange as the only option voted on. Republicans, who want to extend the cuts to all taxpayers, would be put in an awkward position: Vote yes on holding down the tax rates only for middle and lower incomers or be painted as favoring higher taxes for all.

But here’s why that option is no slam dunk. Even a temporary partial extension costs. Deficit hawks will balk, pointing to Europe’s recent woes as an object lesson in the need for U.S. policymakers to impose fiscal austerity sooner, rather than later. And Republicans may hold out for an extension for all taxpayers. Among their arguments: Raising taxes on high incomers punishes small businesses.

Lawmakers may duck, putting off the tough decision until next year and keeping the lower Bush-era tax rates in force at least through 2011.

There’s no such punt possible on estate taxes, though. Even liberals don’t want to see the top rate soar to 55%, with the $1-million exemption returning, which is what will happen at the end of this year if lawmakers don’t intervene.

The odds of resurrecting 2009 rules for 2010 estates get shakier as time passes. Those estates may get a choice: Use 2009’s $3.5-million exemption and 45% top rate or enjoy no estate tax this year but be stuck with carryover basis rules. Then, starting in 2011 -- a phase-in of lower rates and higher exemptions.