Michael Sisk
09/01/2004
Alan Greenspan, in the grips of an unusual bout of verbal clarity, recently fell back on the most hoary cliché in economics to sum up the roots of our government’s budgetary quandary: “There is no free lunch.” President Bush’s administration has laid out a feast of tax reductions (of which Greenspan is an ardent admirer), but it has not paid for it with offsetting spending cuts, the often-enigmatic Fed chief warned.
We have heard this concern before; similar
worries accompanied the Reagan administration’s pairing of tax cuts and spending
increases in the 1980s. However, unlike budget deficits in years gone by, the
sea of red ink in which we now swim, Greenspan and others argue, is a secular
phenomenon, not a cyclical one.In a speech in May, Greenspan warned, “Our fiscal prospects are, in my judgment, a significant obstacle to long-term stability, because the budget deficit is not readily subject to correction by market forces that stabilize other imbalances.”
The economists among us rarely worry about cyclical deficits—they resolve themselves, for the most part, as the economy grows and throws off more tax revenues, as happened in the 1990s. However, a secular deficit is a more rare and troubling breed, more often seen in crisis-racked third-world nations than in economic powerhouses. It does not wax and wane as the economy moves through its cycles; it is not amenable to a natural resolution. It needs to be fed with new revenues, or tamed with painful budget cuts.
| TOP VIEW Economists say the United States is in the grips of an unusual, secular budget deficit caused by a combination of higher government spending and lower tax revenues. The costs of entitlement programs, homeland security and the war in Iraq have deepened the deficit. The odds of a tax increase to close this gap are better under a Kerry administration than they are under a second Bush administration, but opposition in Congress may stall efforts to balance the books by either candidate. Despite this, most believe that the deficit will eventually require taxes to rise. |
The tax cuts enacted in 2001 and 2003 (see “Sunset Schedule,” at the end)—affecting income, dividend, capital gains and estate taxes—suddenly look vulnerable. This is especially so of the capital gains tax, now at a historic low, and the estate tax, slated to wink out of existence at the end of this decade. “No one I know of actually believes the estate tax will go to zero in 2010,” says Don R. Weigandt, managing director at JP Morgan Private Bank in Los Angeles. “A few people within the Beltway think it won’t be repealed, but they live in a parallel universe.” The administration premised its tax reduction initiatives on a budget surplus the government expected to run well into the next decade, which has proven chimeral. “Before the ink was dry on the [estate tax reduction], the federal budget surplus that was supposedly funding it had dried up,” Weigandt points out.
“Weak-kneed members of Congress may well roll back tax cuts to reduce the deficit,” says Scott Hodge, president of the Tax Foundation, a nonpartisan tax research group founded in 1937 and based in Washington, D.C. “Members of Congress are more comfortable raising taxes than cutting spending. The solution is always to raise taxes, not cut entitlements.”
Staggering Shortfalls
Economists and politicians always debate the wisdom
of tax increases or cuts. However, there is an unusual consensus growing over
the scope and nature of the current deficit. Most will agree that it is
alarmingly large; larger certainly than it would appear based on the White House
budget, which omits the costs of the war in Iraq. There is also broad concern
that it will get much bigger if tax rates remain the same and the entitlement
programs (especially Social Security and Medicare) are not reformed before the
country’s 77 million baby boomers start retiring in the next decade. Also, most
observers agree that it is impossible for the country to grow fast enough to
generate adequate revenues to balance the budget.
| “With the economy and the size of the deficit, we view a tax hike as highly probable. We have a structural deficit: In other words, it needs more revenue;
it is not going to fix itself, no matter how the economy performs. Given that,
there is a certain air of inevitability to higher taxes. The capital gains tax
is lower than it has ever been, and I am fairly certain that’s going to be one
of the first places that they turn to increase revenues.” —Bill Baldwin, president, Pillar Financial Advisors |
Entitlement programs are particularly troublesome, since they are difficult to modify. A chunk of the deficit is due to the passage of the prescription drug plan for Medicare, an expensive addition to an already underfunded entitlement. A report released in June by the National Center for Policy Analysis says, that in 10 years, one out of every seven income tax dollars will be needed to fund Social Security and Medicare; in 15 years they will absorb one out of every four dollars.
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| SOURCE: CONGRESSIONAL Budget Office projections, January 2004. (Click image to enlarge) |
Presidential Positions
Although neither presidential candidate is a deficit hawk, each would undoubtedly take a different approach to the problem. Bush has worked long and hard to make his position clear: no tax increases, period.
| “A few people within the Beltway think [the estate tax cut] won’t be repealed, but they live in a parallel universe.” |
In the first two years after the election, “I don’t see a rollback in any taxes unless there’s a change in the White House,” says the Tax Foundation’s Hodge. “Bush has staked so much political capital on the tax cuts; I think there’s a pretty good chance that he would make them permanent. He’d likely come in with political capital and strong momentum and could well make cuts permanent.”
Hodge predicts that the
administration would tie this into a larger tax reform effort. An emphasis on
consumption taxes and de-emphasis on savings and capital gains taxes would be
consistent with Bush’s past preferences.
| “If Kerry wins but there is still a Republican-controlled Congress, the likelihood of an increase in taxes is still not all that significant. That stalemate could project forward a couple of more years.” —Wes French, executive vice president, Wilmington Trust |
Bush may also tighten current rules on charitable giving. A bill currently working its way through the Senate Finance Committee seeks to require a fair market assessment of the value of the gifts taxpayers deduct. Whether the gift is a car, property or work of art, the legislation would require the reporting of the actual sale price of an asset, not just its theoretical value. Bush could sign such a bill without breaking his tax promises.
The tax environment under
a Kerry administration is more uncertain. He has promised to roll back tax cuts
that only benefit families making more than $200,000 a year. Specifically, he
would seek to restore the top two tax rates to their levels under President
Clinton—the 39.6 percent and 36 percent rates (today the highest rate is 35
percent). He would also raise the capital gains tax back to 20 percent and the
dividends tax from 15 percent to 39.6 percent for families on income earned
above $200,000.Kerry says that he would provide a tax break for small businesses and family farms by immediately raising the estate tax exemption to $4 million for a family and $10 million for a family-owned business or farm. He indicates that he would maintain the estate tax for the largest estates.
| Many believe that deficits hurt the economy by driving up interest rates. William G. Gale, an economist at the Brookings Institution in Washington, D.C., and codirector of the Tax Policy Center, says, “The deterioration in the budget outlook since January 2001 will, by 2012, raise interest rates by 125 basis points, reduce annual national income by $340 billion (more than $2,900 a household), and increase U.S. indebtedness to foreign investors. The adverse effects would persist and grow over time.” |
Clint Stretch, director of tax policy at Deloitte & Touche and a veteran of the legislative counsel staff to the Joint Committee on Taxation, believes the estate tax cut would be most in danger of repeal under a Kerry administration. The estate tax will probably not drop to zero in 2010, as currently envisioned, Stretch suggests; however, the exclusion may rise.
Market Realities
The political landscape is not the only factor driving tax policy; the financial markets may have an even greater effect than political exigencies. “We don’t know what message Wall Street will send about fiscal discipline next February,” Stretch notes. “Whatever that is, Congress will go along.” He remembers being summoned in February 1982 to the office of then-chairman of the House Ways and Means Committee Dan Rostenkowski. Wall Street financiers had told Rostenkowski they thought the deficits created by the Economic Recovery Tax Act of 1981 were too high. The result was immediate: The White House and Congress pushed through the Tax Equity and Fiscal Responsibility Act of 1982 in order to offset some of the revenue loss.
Bruce Bartlett, a
veteran of the Reagan administration, who is now a senior fellow at the National
Center for Policy Analysis, agrees that Wall Street sentiment or a market-moving
event—such as a crisis in the housing sector—will force politicians to take
action on the deficit faster than any election-year posturing. “There will be a
triggering event—I’d guess within the next year or so—that turns the deficit
from a nonissue to an issue,” he predicts.
| “It’s widely agreed by experts on both sides that the combination of entitlements and tax breaks is not sustainable.” |
All this is giving professional wealth managers and their clients a lot to contemplate. “The old knee-jerk that a tax deferred is a tax saved may not be true now,” JP Morgan’s Weigandt explains. “With a 15 percent capital gains rate, it’s hard to imagine it going any lower.”
| “The GOP has a 21-seat margin in Congress, so it’s unlikely that, even if Kerry
wins, you’re going to have a huge Democratic majority in Congress. You’re more
likely to have gridlock. It’s not going to be as easy as Kerry is expecting it
to be to roll back all of the Bush tax cuts.” —Holly Isdale, managing director, Lehman Brothers |
The Bush administration’s tax cuts are only temporary—although if the administration gets a second term it may labor to make them permanent. Here are the current sell-by dates:
Income Tax: The top marginal rate remains 35 percent until 2011, when it reverts to its 2001 level of 39.6 percent.
Capital Gains: This tax remains at 15 percent until 2009, at which point it reverts to 20 percent.
Dividends: The tax on dividends is 15 percent until 2009, when it reverts to the taxpayer’s marginal rate, up to 39.6 percent.
Estate Tax: The exclusion on the estate tax increases, and the tax itself declines, in stages until 2010, when the rate falls to zero. The next year the tax rate reverts to 55 percent on everything above $1 million.
Illustration by Matt Mahurin.
Additional Information
When the Levies Break
Taxing Decisions