Presidential Tax Plans: How the Next President Will Affect the Economy

Personal Finance

The winning candidate in November is going to get handed a gigantic sandwich when he swears in the 2013 cabinet and senior staff – and he’s not going to like the flavor.

May God help whoever wins the 2012 election, especially if sequestration – the across-the-board 9 percent cut in discretionary spending – and the impending fiscal cliff come to take place.

(For the most recent odds of the 2012 election results, see NerdWallet’s daily updated statistical Presidential Election Prediction model.)

What is A Fiscal Cliff?

No matter what happens (almost), the U.S. economy is going to get battered by a combination of factors that economists are referring to as the “fiscal cliff.”

What’s the cliff?

In a nutshell, the fiscal cliff consists of the following elements – all set to take effect on January 1:

  • An across the board hike in personal income tax rates as the Bush tax cuts expire.
  • Expiration of federally extended unemployment benefits for some 400,000 workers.
  • An additional 2 percent of income coming out of workers’ pockets, as the payroll tax holiday ends.
  • The expiration of the AMT fix, throwing hundreds of thousands of middle class families into the gaping maw of the alternative minimum tax. This will substantially reduce the after-tax income of a lot of families with children, a home mortgage, and other common deductions.
  • The expiration of the current “doc fix.”
  • Widespread cancellation of federal contracts, resulting in substantial layoffs among military contractors, manufacturers, and just about any other company relying substantially on business with the federal government.
  • A series of new taxes thanks to the Patient Protection and Affordable Care Act, including a 10 percent tax on medical supplies and an additional 3.8 percent tax on capital gains for some taxpayers.

Congress may well strike a deal to avoid the sequestration cuts – but it won’t be pretty. The Congressional Budget Office estimates that the combined effect of all the elements of the fiscal cliff threaten to throw the economy into a double-dip recession: A contraction of 2.9 percent in just six months.

Enjoy your term, Mr. President.

The Candidates On Your Taxes

Mitt Romney is touted as the lower tax candidate for the rich. That’s no surprise: The GOP is normally the party of low taxes and – in theory, anyway – restrained government spending. But low taxation isn’t the entire story. The economy relies, to a large degree, on federal spending, just like a junkie who needs that daily fix, and gets violently ill when he can’t get it.

If the deficit is to be eliminated and the federal debt is to be reduced, federal revenue must ultimately be greater than federal spending, one way or another. And whether we accomplish that by emphasizing tax hikes, as Obama advocates, or spending cuts, as Romney advocates, either way it is an anti-expansionary policy of austerity, and will inhibit economic growth. A recession in 2013 may already be written in the stars.

Income Taxes:

Let’s lay them out, side by side.  Federal income tax brackets, current versus proposed:

Romney has also suggested a broad-based tax-reform aimed at simplifying and streamlining the revenue code. But if that’s going to happen, he is thus far leaving the details up to Congress. One idea Romney has put forward: Make his proposed lower marginal brackets revenue neutral by limiting total overall deductions to, say, $17,000 per year.  Romney has come under attack, however, for not citing exactly what the details of this plan would look like and how it would be paid for.

The Alternative Minimum Tax

Originally passed in 1969 to snag just a few hundred high-income individuals who managed to use tax shelters and passive losses to avoid almost any income tax liability, the alternative minimum tax is there to ensure that anyone with significant income pay at least some income tax. For certain affluent taxpayers, the AMT disallows certain commonly taken deductions. The problem is that when the AMT was written, there was no inflation adjustment written into the law. Instead, Congress has been adjusting the AMT exemption upward each year in a series of temporary fixes.

The AMT was not originally intended to snag the middle and upper middle class. But it is doing so more and more. Now it is routine for families with two professional spouses, a home mortgage interest deduction and a couple of children to fall prey to the AMT. If Congress doesn’t keep the fix in place, some 40 percent of married couples will get whacked with it.

Both presidential candidates would like to be rid of it. Romney wants to scrap it completely; Obama wants to replace the AMT with the so-called “Buffett Rule.”  According to the Obama White House, the Buffett Rule is this:

“No household making more than $1 million each year should pay a smaller share of their income in taxes than a middle class family pays.”

In practice, though, the Buffett Rule involves a de facto increase in capital gains taxes for the wealthy – the next section explains why.

Capital Gains Taxes

The current regimen is this:

  • Short-term gains are taxed at the same rate as ordinary income.
  • Long-term gains are taxed at zero for those in the 10 and 15 percent brackets, and at 15 percent for everyone else.

As of January 1, the top rate on capital gains increases by 33 percent, to 20 percent. Which means a corresponding reduction in the value of assets, under the principal of tax capitalization.  It states:

A lower tax rate directly increases the value of an economic asset through the phenomenon known as “tax capitalization.” Whenever the cost of holding an asset declines, its value increases, since the owner now will be required to pay less each year. This improvement of the owner’s cash flow is capitalized into the price of the asset. Tax capitalization in property values is well established in commercial practice, the law of taxation and assessment and the financing of homes.

Remember the wealth effect? Well, an increase in the capital gains tax will mean the wealth effect happening in reverse.

Back to the Buffett Rule: The principle reason that the wealthy pay a lower effective tax rate, in some cases, than the middle class, is that we encourage investment by giving it a more favorable tax rate than we give to income from labor. Long term gains are taxed less than the marginal dollar you earn on your W-2 statement. The logic is that the money that capitalists are investing has already been taxed once – as income. Strip that away, and you strip away a powerful incentive to invest.

The wealthy also invest quite a bit in municipal bonds. City and state governments rely on the lower  interest rates they can pay on debt to finance their own operations and payrolls thanks to the fact that municipal bond income is generally not federally taxable. So you can increase effective taxes on this money – but city and state governments will pay dearly in higher interest rates to attract bond buyers.

Conservatives like GOP Vice Presidential candidate Paul Ryan oppose the Buffett Rule for this reason.

Municipal Bond Interest

As we mentioned, interest on most municipal bonds is federally tax free, with the exception of private activity bonds for those subject to the AMT.  Both Romney and Obama are in favor of limiting the tax-free status of municipal bonds for higher income taxpayers, though. This could put pressure on state and local government budgets – which are already staggering under the strain of immense pension and retiree costs.

The Estate Tax

Obama wants to tax estates over $3.5 million at 45 percent. Romney, quelle surprise, says he would like to eliminate it. Surely that measure will go over well with his five sons.

Taxes on Dividends

Romney proposes eliminating the tax on dividends and capital gains for those making less than $200,000 per year. This is a big deal, because it will reduce the appeal of tax-advantaged retirement funds for the vast majority of workers. If there is no tax on capital gains, and dividends aren’t taxed, then there is little incentive, other than asset protection, for workers to submit to a 10 percent penalty for early withdrawals on stocks and stock funds. The danger is that absent a formally segregated savings account, workers won’t save!

Incidentally, Romney’s plan could also mean a reduction in the appeal of annuities. Annuity returns are generally taxable at ordinary income rates. So on an after-tax basis, taxable annuity income will be that much less attractive than returns you take from a taxable investment portfolio.  If annuity sales fall as a result, this will eliminate an important hedge for the life insurance industry, which could, in turn, affect how life insurance is priced.

Obama would like to increase the tax on dividends and capital gains for taxpayers in higher income brackets. In fact, he’s already accomplished this, thanks to a 3.8 percent surtax on capital gains, generally applying to those with incomes over $200,000 (or couples with incomes over $250,000).

Corporate Taxes

Currently, the tax on C corporations is at 35 percent. Both candidates want them reduced. Obama wants to reduce corporate tax rates to 28 percent, and 25 percent for manufacturing. Romney wants them to be at 25 percent across the board. This should help make American industries more globally competitive, and do a small bit to encourage the repatriation of money American companies have earned abroad – and which they keep invested abroad to avoid the steep U.S. tax rates on corporate profits under current law.

Oil and Gas

None of us are immune to oil and gas costs. We all pay the price for increased gasoline and heating oil costs, either directly or indirectly.  Obama has advocated eliminating existing tax incentives for oil and gas exploration. His 2012 budget proposal raised taxes on the oil and gas industry by $43.612 billion over 10 years. Romney has not specifically addressed oil and gas taxes, but has indicated recently, including during the 2nd presidential debate, that he would advocate policies that help the oil and gas industry.

Overall

If Obama wins, his policies will likely be held in check by a Republican leaning House of Representatives. He will probably fight to keep ObamaCare in place, and unless Republicans can take back the Senate, he will probably succeed.  If Romney wins, he will likely be checked by a Senate that is either run by Democrats or run by Republicans trying to work around the constant threat of a Democratic filibuster.

Either way, Congress will likely prevent major radical new initiatives on the part of either party.  Economic shocks won’t come from new policy initiatives so much as a government trying to come to terms with the fiscal cliff and a struggling global economy.