Long term not short term economic policies preferred

August 30, 2010
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Congress will return in September to consider additional tax and small business legislation prior to the November elections.

Weekly jobless claims numbers released in August show the ranks of the unemployed may be growing, not declining, despite a few jolts of stimulus in the economy.

A quick recap of the stimulus incentives may be in order. There have been different tranches of stimulus enacted in the past two-plus years. This includes the February 2008 package of tax rebates, the February 2009 package of incentives and, lastly, the summer of 2009’s “Cash for Clunkers” incentive. These three programs provided approximately one trillion stimulus dollars into the economy with mixed and heavily debated results.

Many politicians have argued that the unemployment rate may actually have been higher if no stimulus was enacted. It is not clear whether that assessment is correct. In the meantime, regulatory reform and health care reform have caused uncertainty with respect to the cost to business.

This past spring, the nation was a recipient of another incentive package, the Hiring Incentives to Restore Employment Act, which added a payroll tax credit for hiring and retaining new employees. Congress is set to take up a new incentives package in September that proposes to infuse community banks with investment so banks will lend to small business so that the businesses will expand and hire additional employees. There also has been talk in recent weeks of a new incentive  package and the rhetoric on whether a portion of the Bush tax cuts scheduled to sunset in 2011 should be retained in some form. Also, Congress has yet to address tax provisions that expired Jan. 1, 2010. And there has been no significant movement on the estate tax that expired Jan. 1 and will reset to pre-2001 levels in 2011 if nothing is done.

With all the uncertainty with respect to taxes, it’s no wonder why many businesses have decided to delay investment, expansion and hiring decisions until there is a clearer picture of the future.

The Wall Street Journal made an interesting observation earlier this year regarding the use of short-term stimulus initiatives. It observed that President Jimmy Carter used a jobs credit program, and noted that the jobless rate then declined from 7 percent in 1977 to 5.8 percent in 1979. The tax credits expired and the jobless rate grew to 7.2 percent in 1980. Granted, other factors may have contributed to the increased jobless rate, but the point is that longer-term policy may have longer-lasting impact than short-term fixes.

We have certainly heard the rhetoric that the focus in Washington needs to be jobs. As I was preparing to draft this column, I took a quick glance at the various federal jobs credits available. There are, of course, the recently enacted hiring and retention incentives in the HIRE Act. The HIRE Act includes provisions such as a payroll tax holiday for employers for a period of time and a credit against income tax for retaining new employees. There are some older employment-based tax credits also available, such as the Work Opportunity Tax Credit (which absorbed the Welfare to Work Credit a couple of years back), the Indian Employment Credit, the Credit for Payroll Taxes paid on Employee Tips, and the Empowerment Zone and Community Employment Credit.

There have been some interesting discussions on the nightly CNBC program “The Kudlow Report” on what fiscal and tax policy goals should be in Washington. The program has recently instituted a countdown for the days remaining for the Bush tax cuts. There are increasing arguments that the renewal or expiration of these tax cuts may have a bigger impact than any jobs credit set of incentives. There is the common argument that government should never increase taxes during times of economic recession or economic slowdown.

There is also the argument that the vast majority of the job creation activity in the U.S. is by small business. Small business is predominately conducted by sole proprietors, partnerships (including LLCs) and S corporations. All of these have one thing in common: They all pay federal tax using the individual tax rate schedule since the results of their businesses are taxed on an individual taxpayer’s Form 1040.

One argument is that increasing the individual tax rates schedule results in fewer dollars available for small business to invest and expand and to hire new employees. Most believe it’s better that small business hires employees for the long term than the government to enhance its revenues by hiking taxes and then creating short-term stimulus and make-work programs. 

What exactly happens if the Bush tax cuts expire? Let me share a couple of observations:

The long-term capital gains tax rate jumps from 15 percent to 20 percent, a 33 percent change in the rate of tax. Certain assets held more than five years are taxed at 18 percent. Many credit the drop in the long-term capital gains tax rates from 28 percent to 20 percent in 1997 with spurring the economic growth in the last years of the Clinton administration and creating the budget surpluses that existed as he left office. Also, the expiration of the 2003 tax cuts will result in a significant tax increase for those earning dividend income. The current rate of qualified dividend taxation is tied to the capital gains rate. That link will expire in 2011. Thus, ordinary income marginal tax rates will apply to qualified dividend income.

Thus, for many, the top marginal rate of tax will jump from 15 percent to 39.6 percent (before consideration of some other tax hikes contained in other legislation). That is more than a 260 percent hike in the tax liability on qualified dividend income. This will occur when most of our trading partners have lowered their effective rates of tax on dividend income by virtue of the use of some form of tax integration regime for dividends. The integration takes into account that the dividend results from corporate income already being subject to one level of taxation at the corporate level, and to fully tax the income again is double taxation. Australia, Canada and the U.K. all use some form of tax integration mechanism to reduce the impact of double taxation on dividend income. In recent days, the voters of Australia put the majority government into a minority position after the party in power had proposed significant tax increases on the mining industry.

Washington will have its hands full this autumn. The election cycle and the news cycle may limit constructive debate regarding tax and fiscal policy. Pandering and sound bites may become the fare for the moment, and we may lose another opportunity to focus on longer-term policies for our nation.

William F. Roth III is a tax partner with BDO USA LLP. The views expressed are those of the author and not necessarily those of BDO. The comments expressed are general in nature and not to be considered as specific tax or accounting advice and cannot be relied upon for the purpose of avoiding penalties. Readers are urged to consult with professional advisers before acting on any items discussed herein.

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