Runaway Deficit Leaves Pols With Awful Choices on Taxes

Dec. 1, 2010 — -- Uncertainty about Americans' tax future reigns in Washington: Will Bush-era tax cuts be allowed by Congress to expire Jan. 1 or will they be extended? And if extended, how long and for whom? A meeting yesterday between the president and Republican leaders did little to clarify what taxpayers can expect in 2011.

"It's a mess!" says attorney Barbara Weltman. "I've never seen such uncertainty." She's been dispensing tax and business advice for 30 years.

At last count, Congress was entertaining five options: No extension of any tax cuts. Permanent extension of all tax cuts. A two-year extension of all cuts. President Obama's proposal for permanent cuts applying only to the middle class. And a two-year extension only for the middle class.

Correction: Six options, says Ingrid Schroeder, director of the Pew Financial Analysis Initiative—a project aimed at strengthening the U.S. economy: Whereas Obama's proposal defines the middle class as anyone making up to $250,000 a year, a sixth proposal now circulating defines middle class as anybody making up to $1 million.

Among these several scenarios, what's the best and worst outcome a middle class taxpayer can expect?

"The best," says Clint Stretch, managing principal for tax policy at Deloitte Tax LLP in Washington, D.C., "is that between now and Christmas Eve, Congress decides to extend middle class cuts for some period of time—maybe three months, maybe two years."

Hardly anyone in Washington, he insists, believes that middle-class tax cuts should not be extended by a few years. One reason: The U.S. is still recovering from the recession. Says Schroeder, "We're in a fragile situation right now. That's why people are considering an extension."

How about the worst outcome? Says Stretch, "The possibility that Congress will do nothing, and that on January 1st tax rates will go back to what they were in the Clinton administration. A married couple with two kids, let's say, making $70,000 a year would see their taxes go up $2,600. That's $50 less in your paycheck every week."

The increased tax bite on someone single with the same income (but no kids) would be $1,300.

If Congress lets the cuts expire, Weltman says that take-home pay will be lower in 2011 than it was in 2010. She cautions that employees may experience "sticker shock" when they see their first paycheck of the new year.

Among the changes workers can expect if the cuts expire:

-The lowest tax bracket, currently 10 percent, will rise to 15 percent--in effect, a 50 percent increase.

-Reinstatement of the so-called marriage penalty: "Married employees," says Weltman, "will no longer have relief through the 15 percent tax bracket but will pay more than two single individuals with the same income."

-The child tax credit—currently $1,000 for families with a child under 17—will drop to $500. "A lower credit means a higher income tax on the parent-employee."

-An increase in the supplemental tax rate: Persons receiving bonuses, commissions, or other forms of supplemental pay will see payroll withholding rise from today's 25 percent to 28 percent.

Whether or not Congress extends the tax cuts, Weltman says, other tax changes promise to make 2011 a challenging year. They include:

-Expiration of the "Making Work Pay" tax credit, which for the past two years has plumped a few bucks more take-home pay ($7.70 a week for individuals) into the wallets of the middle class.

-A reduction in the deductibility of commuting costs (currently up to $230, but up to only $120 next year).

--Expiration of the American Opportunity Credit, which had allowed parents jointly making up to $160,000 to take as a tax credit up to $2,500 for money spent on their kids' college costs.

She calls the sum of all these changes "a perfect storm" for taxpayers.

What if tax cuts were extended longer than two years—for a decade, perhaps? Would that be a good thing for the middle class?

Hard to say.

No one of any class wants to live in a country that's going broke--and that's what the U.S. risks long-term if it fails to pay down its ballooning debt. Tax cuts can be viewed as just that much less revenue available for debt reduction.

Ten years from now, says Stretch, if tax cuts are left in place, the U.S. deficit could grow to 7.5 percent of GDP. "At 8 percent, all of the government's revenue would have to go just to paying interest on the debt. You don't want to exceed 2 percent to 2.5 percent, otherwise you're digging yourself a hole you can't get out of," Stretch says.

The dilemma for the middle class, he says, is this: You can have your tax cuts now; but eventually the federal government, in desperation, will need find other ways to increase revenue—a value-added tax, perhaps, or a tax on your 401K. Costs will have to be reduced. Benefits will shrink and services will be curtailed. The road outside your house may get paved less often.

It all comes down to the age-old question: Do you want to pay now, or later?