By: Roshawn Watson
People can change the volume, timing, and the location of their income in response to changes in tax policy. Next year, the highest federal personal income tax rate will go from 35% to 39.6% , the highest federal dividend tax rate increases from 15% to 39.6%, the capital gains tax rate increases from 15% to 20%, and the estate tax rate increases from 45% (in 2009) to 55%. With the steep increases in federal, state, and local taxes scheduled for next year, will economic activity be stifled to the point of economic collapse in 2011?
The Laffer Curve
Economist Art Laffer, creator of the Laffer Curve certainly thinks so, and he has provided some compelling arguments.
When we pass the tax boundary of Jan. 1, 2011, my best guess is that the train goes off the tracks and we get our worst nightmare of a severe "double dip" recession.His basic premise is that there is a point where increased taxation no longer results in a corresponding increased revenue for the government: there is a sweet spot with respect to taxation. Maryland certainly felt the impact of over-taxing its residents when lawmakers enacted a special millionaire tax to cover budgetary deficits. The profound result was millionaires paid over a $100 million less in taxes compared to year prior to the enacting the tax, even though the tax rate was higher. Maryland literally lost one-third of its millionaires in a single year, and most believe it is partly attributed to enacting the millionaire tax. From those missing millionaires, Maryland collected nothing. Simply put, you just cannot tax people beyond their willingness to pay. The classic example is if you were taxed at a rate of 120% of your income, how long would you work?
Impact of Anticipating Higher Taxes on Economic Activity
Anticipation of higher taxes will motivate people to shift income and production from next year to this year. Consider billionaire Eddie Lampert. According to Bloomberg & Business week, his hedge fund distributed him $829 million in stock this year, so far. The fund is scheduled to transfer more shares to Lampert by the end of July. Because he is taking the stock now, he will be taxed at the current capital gains rate of 15% when he decides to sell. However, if he were to wait until next year, under proposed legislation in Senate, he would pay the higher ordinary-income tax rate of 39.6%. Robert Willens owns a New York firm that specializes in reducing tax burden of its Wall Street clients. Willens commented that Lampert's decision to take a stock distribution is totally astute and "(i)t doesn’t take a fortune teller to predict that we are going to see a lot of this activity between now and the end of the year.” In addition to retaining the capital gains treatment of the stock, Lampert still controls the timing of the sell, so he can determine to sell during a year that minimizes his taxes. Frank McCourt, owner of the LA Dodgers, illustrates how timing such a transaction can dramatically reduce one's tax burden. He recently received $108 million in income and paid no federal and state taxes because of loss-carry forwards.
Laffer further argues that this pattern of shifting economic activity based on tax policy occurs repeatedly and can have a profound impact on the economy. A poignant example occurred in the early 1980s. The majority of Reagan's tax cuts didn't go into effect until 1983, and people consequently delayed economic activity in 1981 and 1982 to the point where the real GDP was flat (no growth) while the unemployment rate rose to 10%. However, the pent-up economic activity took off in 1983 , as growth increased to 7.5% and further increased by 5.5% the following year. Accordingly, the impact of the deferred tax increases for next year may be in reverse, and Laffer predicts the economy will collapse in 2011.
This is the product of removing incentives for production through increased taxation.
The fact that corporate profits as a share of GDP are already too high given the state of the U.S. economy reflects the shift in income into 2010 from 2011. "These profits will tumble in 2011, preceded most likely by the stock market" according to Laffer.
Regardless of your views about a potential double dip recession, some feel all of this complaining about taxes is going too far. After all, aren't we just raising income taxes back to pre-Bush levels? Consider that a chief justice once said that a citizen has not only the right but a duty to pay only the minimum tax applicable to him. It sounds like even chief justices aren't so keen on paying taxes either. The point is taxes are not a trivial thing. Taxes typically represent our single largest lifetime expense: we're taxed when we earn, spend, save, invest, and die. It's naive to think that changing tax policy doesn't affect consumer and business behavior. Indeed, the nine states without an income tax are growing far faster and attracting more people than are the nine states with the highest income tax rates. This is simply a fact.
Laffer Is Not Infallible
Art Laffer is certainly not infallible (after all, who is?). Recall four years ago, he argued with Peter Schiff about the the probability of whether we would enter a recession in 2007 or 2008. His words were "the economy has never been in better shape (watch it for yourself)." Of course, this prediction was inaccurate, and he subsequently admitted so.
Of course, Laffer isn't the only prominent economist fearing a double dip recession. Nouriel Roubini argues that the U.S. recovery is far from a sure thing yet. He believes the recovery has a 60% chance of being slow and anemic with little growth for the next two years; however, his modeling also suggests that there is a 20% chance that we will have a double-dip recession. Side note, Dr. Roubini did correctly predict that the US would enter a recession in 2006, just as Schiff.
It's Your Economy That Matters
With $13 trillion in debt, our economy certainly has seen better days. Better unemployment news helps, but there are some tangible challenges we face. Regardless of whether we are heading towards a double-dip recession next year, as I said in May 2008, what's most important to you is your economy. "Will your finances be screwed up next year?" is a much more relevant question to you than whether or not we will have another recession. If you have a stable income there is no time like the present to get your finances in order. Consider discussing with your accountant the implications these changes to the tax laws will have on you. Perhaps, this may be the time to take a capital gain, or convert a traditional IRA or a 401K to a Roth IRA for tax free growth if you can afford to pay the taxes this year. For 2010, the prepayment penalties are waived. My wife's first response to Laffer's predictions was "how can we prepare?" What's your first response?
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