Give U.S. Companies Certainty On Taxes

In trying to ignite its economic recovery, the US should look to its companies since they have record levels of cash. For example, UPS has increased its cash from $2bn to $4bn over the last six months. By contrast, the American consumer is largely tapped out, with substantial debts held by most and unemployment faced by many.

But leaders of American companies are reluctant to invest their cash in light of the high level of political and financial uncertainty. In particular, they are concerned about the uncertainties surrounding taxes due to the fierce battle between Democrats and Republicans on this subject. They do not know the tax rates for 2011 on ordinary income, capital gains, dividend income or large estates.

Following is a compromise that should be acceptable to both parties, though neither will praise it.

1. Keep the Bush tax cuts for all individuals through to the end of 2011, and then raise only the top tax rate on ordinary income from 35 per cent to 39.6 per cent.
2. Set the tax rate permanently at 20 per cent for all capital gains and corporate dividends.
3. Exempt the first $4m per person from estate taxes, with a rate of 30 per cent on the next $10m and 45 per cent above that level.

The US cannot afford to make permanent the Bush tax cuts on ordinary income for all individuals because that translates into $1,700bn in lost revenues over the next decade. Of that amount, close to $700bn would be revenues lost by the Bush tax cuts for ordinary income over $250,000 per year.

As we saw during the 1990s, the US economy can grow quite nicely if the top tax rate on ordinary income is 39.6 per cent rather than 35 per cent. However, even some Democrats recognise that the economy is too fragile at this time to be raising taxes on anyone.

To reconcile these long-term and short-term considerations, Congress should extend the Bush tax cuts for everyone until the end of 2011. At that time, the tax rate on ordinary income above $250,000 per year would be automatically increased to 39.6 per cent.

Even if Congress allows the Bush tax cuts to expire, the tax rate on capital gains would rise from 15 per cent to only 20 per cent. Although investors would prefer a 15 per cent rate, they can tolerate a 20 per cent rate on capital gains.

By contrast, if Congress allows the Bush tax cuts to expire, the tax rate on dividends would jump from 15 per cent to as high as 39.6 per cent. This is not acceptable to investors. Moreover, it creates a perverse incentive for successful companies to stop paying dividends to investors and instead buy back company stock. Although raising dividends typically gives a boost to a company’s stock price, the impact of stock buybacks has been uneven.

The best compromise seems to be a permanent tax rate of 20 per cent on both capital gains and dividends. That would be considerably lower than the rate on ordinary income, and would not create any artificial incentives to choose capital gains over corporate dividends.

Despite much acrimonious debate, I believe there is a strong consensus in Congress to continue the estate tax, but with exemptions large enough to avoid taxing the estates of almost all farmers and small family-owned businesses.

This objective would not be achieved if Congress does nothing before 2011. In that event, the estate tax would revert to its pre-Bush status with an exemption of only $1m per person and a tax rate of 55 per cent.

Although some Republicans would like to eliminate the estate tax, they would be even more upset if we went back to the pre-Bush status on either the exemption amount or the rate. In 2009, most Democrats seemed comfortable with an exemption amount of $3.5m per person and a top tax rate of 45 per cent. This structure for the estate tax would achieve the objective stated above.

Both Republicans and Democrats should recognise that it is especially absurd to have no certainty on the estate tax since this, by its nature, requires advance planning. As a political compromise, Congress should enact a permanent solution to the estate tax issue with an exemption of $4m per person (indexed to inflation), a tax rate of 30 per cent on the first $10m above the exemption amount, and a tax rate of 45 per cent beyond that level.

In short, while taxes tend to provoke heated ideological arguments, both parties have a strong interest in promoting a stronger economic recovery in the US. Congress can help support this goal by providing certainty on taxes for at least the next few years.