You didn't think China would fund America's insane spendorama for ever, did you. Here's Goldman on the second, and much more relevant, part of Obamacare and the stock market reflation trade: tax rates going through the roof.
Tax policy has gained attention in recent days as a result of the tax increases used to pay for health reform. In fact, this is just one of several potential tax debates over the next several months, with the expiration of the 2001/2003 tax cuts and stimulus tax provisions scheduled for year end, proposed and recently enacted corporate tax proposals, and the possibility of some form of consumption tax on energy or, in the longer term, a broader value added tax.
There is little possibility of changes for 2010, apart from the expiration of some stimulus-related provisions, but tax rates in 2011 are almost sure to rise on higher incomes as well as capital income. One consideration for lawmakers will be the different effect that tax policy can have in a zero interest rate environment. This may reduce the negative effects associated with increased taxation of labor and capital, but could exacerbate the negative effect of any increase in consumption-related taxes.
The passage of health reform has done two things to focus attention on tax policy. First, it included a number of taxes to finance a portion of the new spending the package calls for. Second, it clears the agenda for the broader debate on tax policy that will begin in the next few weeks when Congress takes up its budget blueprint for 2011, which will lay the groundwork for the extension of some, but not all, of the tax cuts scheduled to expire later this year.
Tax policy over the next year is likely to see more substantial changes than at any point since 2001, and is likely to see taxation rise more than any point since 1993. After several years of relative stability in tax policy (the stimulus legislation was the one exception), the next few years will require decisions on several fronts:
- Financing of health reform. Just under a quarter of the financing for the new spending in the health bill comes from an increase in the Medicare payroll tax rate on income over $250,000 (for couples) and the addition of a new tax of 3.8% on “unearned income” which includes most forms of income outside of wages, including capital gains, dividends, and interest. These tax increases are scheduled to take effect at the start of 2013. The bill also includes $210 billion in health industry taxes, which take effect between 2011 and 2014.
- Extending the 2001/2003 tax cuts. The administration proposes extending most of the tax cuts set to expire at the end of the year, but would have the top two marginal tax rates increase from 33% and 35% to 36% and 39.6% (as they are scheduled to do under current law) and would set the capital gain and dividend rate at 20%, up from 15% now. We assume that the marginal rate incrases will take place, but that the capital gains and dividend rate is likely to end up closer to 25% for budgtary reasons. Whatever the outcome, the rate increase would take effect at the start of 2011.
- Extending stimulus tax provisions. The two most significant tax provisions in the American Recovery and Investment Act (ARRA) were the “making work pay” credit for individuals, which provides a refund of payroll taxes paid on the first $8,000 of income, and bonus depreciation for corporations. Several other smaller individual and corporate provisions were also included. We assume that the making work pay credit will be extended indefinitely. However, bonus depreciation, which expired at the end of 2009, seems unlikely to be renewed absent significant renewed economic weakness.
- The administration’s corporate tax proposals. The Obama Administration included a number of corporate tax increases in its fiscal year 2011 budget, which if enacted are estimated to raise $440 billion in corporate tax receipts over 10 years. We don’t expect many of these to be enacted this year due to sentiment in Congress that most of these proposed changes would be better dealt with in the context of broad tax reform. Given the crowded political agenda, large-scale tax reform appears very unlikely this year.
- Climate legislation. This may seem like an odd item to include in a discussion of tax policy, but the recent debate over how to deal with carbon emissions has begun to focus on taxes more heavily, in two ways: first, there appears to be growing interest in limiting emissions from the transportation sector through a tax on gasoline; the energy industry has become more open to a tax, the auto industry appears to support it as a means of reducing volatility in fuel prices, and Senators Kerry (D-MA), Graham (R-SC) and Lieberman (ID-CT), who are seeking a bipartisan agreement on a climate bill, appear likely to include it in their approach. An alternative approach, though one that would have similar implications, is the “cap-and-dividend” approach proposed by Senators Cantwell (D-WA) and Collins (R-ME), which would redirect most of the revenue collected from a carbon emissions reduction regime back to consumers through the tax code.
- The fiscal commission and medium-term fiscal consolidation. Shortly after the November elections, the fiscal commission established by the president is due to submit recommendations to Congress on policies to balance the primary budget deficit by 2015. Medicare cuts on top of those just enacted to finance health reform would be difficult to enact, and the president has already proposed a freeze in non-defense discretionary spending, so there isn’t a great deal of spending left on the table to cut (though stimulus- and financial stabilization-related spending will taper off automatically). Therefore, it seems likely that the commission will propose at least some tax increases. It’s not even clear whether the commission will be able to agree on recommendations—a supermajority of members must agree—but if they do, this could lead to the consideration of significant fiscal policy changes toward the end of the year.
There are too many unknowns to predict with certainty what the combined effect of all of the various tax issues up for debate will be, but it is possible to at least take a directional view on where policy is headed:
Higher vs. lower incomes: It seems fairly clear that the income tax rates of higher income taxpayers will increase relative to the rates on lower income taxpayers next year. How much depends on two issues: first, whether Congress extends the tax relief included in ARRA that generally benefits low- and middle-income households, and second, whether Congress opts to allow higher income tax cuts to expire. As noted above, we expect both of these to occur, which should increase the differential between high- and low-income tax rates. This is likely to mean an effective rate for higher incomes similar to the 1990s, while the lower income quintiles remain relatively unchanged from where they are currently (the chart below shows data only through 2006, due to a long lag in reporting by the IRS).
Effective Federal Tax Rates
Labor vs. capital income: Policy is likely take a path leading to increased taxation of passive income, such as capital gains, dividends, and interest, certainly on an absolute basis, and potentially as a share of total taxation. This is due to the likely increase noted above in the capital gains and dividend tax rates as a result of the expiration of the 2001/2003 tax cuts, as well as the taxes on passive income included in the health reform package. The combination of these provisions is likely to mean a rate as high as 25% on both sources of income in 2011, stepping up to roughly 29% in 2013, from 15% today. The chart below puts this move in the context of historical rates on both sources of income.
Historical and Estimated Tax Rates on Capital Income
Income vs. consumption: An increasingly prevalent view among outside observers is that lawmakers will ultimately adopt a value added tax to close the chronic budget gap. There seems to be much less discussion of such a tax among lawmakers themselves, however. This isn’t surprising—there is little reason to promote the possibility of such a tax ahead of an election—but it does indicate that such a tax is probably not just around the corner. That said, it seems likely that the debate over a a federal consumption tax in the US will intensify. First, as noted above, lawmakers have begun what is likely to be a long but gradual push toward fiscal consolidation, with the potential recommendations of a fiscal commission late this year. As we’ve noted elsewhere (for instance see “Fiscal Consolidation: What Will It Take?” US Economics Analyst 10/08, February 26, 2010), a value-added tax or its equivalent could be a politically attractive alternative to increases in the income tax, since the tax rate applied could be relatively low compared with an income tax rate increase. (There are clear drawbacks as well, such as the regressive nature of such a tax and the need to build an infrastructure to collect what would, at least at the outset, presumably be a fairly small tax. This would argue for applying such a tax only in the context of broad reform, so that income or payroll taxes can be adjusted simultaneously). Apart from the possibility of a broad-based consumption tax, whatever legislation Congress ultimately adopts to reduce carbon emissions is likely to impose a de facto tax on consumption of energy. This debate has become more transparent of late, with proposals to tax transportation fuels directly as noted above. Neither of these is likely to have an effect on consumers in the next couple of years, but in both cases the policies could eventually replace some of the current revenue collected from income and payroll taxes.
Personal vs. corporate taxes: Apart from changes in how individuals are taxed, there is also likely to be a shift in the relative taxation of individuals and corporations. The Obama budget, noted above, would increase corporate taxes by 11% compared with current projected corporate tax revenue. The health reform package will increase corporate taxes by another 5% or so (these taxes are concentrated on the health industry), bringing the total increase in corporate tax liabilities to around 16%. In comparison, the personal income tax increases proposed—most of which we think will be adopted—would increase total income taxes by around 6%, and total personal taxes (including payroll taxes) by around half that much. It is also worth noting that the last major tax reform debate, in 1986, modestly shifted tax liability from individuals to corporations.
The tax changes noted above are likely to occur over several years. Tax rates on high incomes and capital income will increase for 2011; tax increases in the health bill phase in between 2011 and 2014, and any taxation that comes out of climate legislation or broader tax reform is likely to be several years off.
The short term effect of these changes could vary substantially depending on when they are implemented. For instance, a capital gains tax increase in 2011 could have a counterintuitive effect, by prompting investors to liquidate holdings this year ahead of the increase in rates. There is empirical evidence demonstrating that investors tend to spend a portion of cash coming into brokerage accounts, though the effect tends to be stronger for dividend income than for capital gains (see for instance Baker, Malcolm P., Nagel, Stefan and Wurgler, Jeffrey A., “The Effect of Dividends on Consumption,” March 2007).
A second possible counterintuitive effect is the significant difference in fiscal multipliers in a zero interest rate environment. A recent paper from the New York Fed explores the possibility that tax cuts on capital and labor could actually have a negative near term effect on demand when rates are at zero, by encouraging additional saving and reducing wage pressure with the eventual effect of higher real interest rates (see Gauti B. Eggertsson, “What Fiscal Policy Is Effective at Zero Interest Rates? Federal Reserve Bank of New York Staff Report No. 402, November 2009).
A more intuitive result is that the multiplier attached to consumption-related taxes increases substantially in a zero rate environment, implying that if lawmakers were to attempt to implement one of the consumption-related taxes in the near term, it could have an even more severe negative effect on demand than it normally would. Of course, these results are relevant mainly to the short term effect of temporary tax policies meant as stimulus rather than the effects of longer term tax decisions. And there are clearly other considerations that must also be taken into account, such as the potential for a capital income tax increase to put pressure on equity prices, thereby decreasing demand. The bottom line is that as lawmakers undertake what are likely to be significant changes in tax policy, they will need to be recognize that these changes will take effect in an economic environment different from any they have encountered in the past.