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Tuesday, December 14, 2010

'Temporary' Tax Code Puts Nation in a Lasting Bind

Wall Street Journal

'Temporary' Tax Code Puts Nation in a Lasting Bind

WASHINGTON—Welcome to the world of the temporary tax code.

The U.S. tax code is slowly being turned into a temporary patchwork of provisions that need to be addressed every year or two, depriving individuals and businesses of the predictability they need for long-range plans. John McKinnon discusses. Also, Brett Arends says not only are the Democrats politically bankrupt and the Republicans morally bankrupt, but that this tax deal will play a big role in America's undoing.

In the late 1990s, there were typically fewer than a dozen tax provisions that had just a limited lease on life and needed to be renewed every year or so.

Today there are 141.

Now Congress, taking up a deal worked out between the Obama administration and Republican leaders, is poised to turn the whole personal income-tax system into something of a temporary structure. The plan embraces a broad range of provisions—an extension of Bush-era rates, a new estate-tax formula—but for only two years. A payroll-tax cut in the bill is for a single year.


This means that if the compromise passes largely intact, the U.S. will have no permanent regime governing levies on salaries, capital gains and dividends, the Social Security tax, as well as a slew of targeted breaks for families, students and other groups. This on top of dozens of corporate-tax provisions that already were subject to annual renewal.

The level of uncertainty, unusual for developed nations, complicates planning and discourages hiring and investment, many economists and corporate executives say.

"I haven't seen anything like it, and it's hard historically to find anything like" the current and pending negotiations, says Mortimer Caplin, an Internal Revenue Service commissioner in the Kennedy administration who at 94 is just three years younger than the income tax itself. "This Congress has left an awful lot up in the air."

A vote to pass the tax deal in the Senate is expected on Tuesday or Wednesday; prospects for swift approval in the House remained cloudy but party leaders seem increasingly resigned to the measure clearing Congress intact.

Democrats are predicting that a tax deal will clear a crucial hurdle comfortably in the Senate today, with a margin they hope will add momentum to the deal in the House. Aaron Zitner and Neal Lipschutz discuss. Also, Nick Timiraos discusses worry among economists that the housing market could be headed toward another downdraft as mortgage lenders tighten credit.

The two-year expiration of the bill's main provisions on individual rates would occur just after the next presidential election, and few in Washington envision a long-term solution being crafted at such a charged time.

At the same time, the possibility of a sweeping tax-system revamp can itself add to the uncertainty, what with politicans increasingly ready to talk about this. President Barack Obama has lately, as has the deficit-reduction panel he appointed, including Republican members such as Rep. Dave Camp, future chairman of the House Ways and Means Committee. The possibility of an overhaul that would put on the table long-established credits and deductions could further uproot predictability.

This year has been something of a test case for tax uncertainty, with concern about what would happen when provisions adopted in 2001 and 2003 expired at year-end.

Sales of certain kinds of life insurance rose as families wrestled with the possibility that estate taxes would jump in 2011. With no assurance the 15% rate on dividend income would last past 2010, Kraft Foods Inc., Exelon Corp. and Altria Group Inc. asked their shareholders to contact Congress in opposition to an increase. Stocks of utilities, which traditionally pay high dividends, appeared to factor in the possibility of a rise in the dividend tax rate in 2011, analysts said.

At Incobrasa Industries Ltd., a producer of biodiesel in Gilman, Ill., sales manager Douglas Santos has been waiting to see what happens to an expired tax subsidy for his industry. He is running at 25% capacity, vs. 100% in 2008. Mr. Santos wants Congress to make up its mind one way or the other. "Just do something," he says. The bill before Congress would restore the subsidy.

Economic research has shown businesses tend to be more reluctant to invest when they perceive high levels of uncertainty about various things, including over taxes. The pressure on policy makers to narrow the budget deficit, not merely simplify the tax system, further muddies the waters now, says Massachusetts Institute of Technology tax economist James Poterba, who finds "the crystal ball…particularly unclear at the moment."

Some call the worries exaggerated. "I truly do believe the concerns expressed over tax uncertainty are truly overblown," says Martin Sullivan, an economist with Tax Analysts, a nonprofit tax publisher, who sees today's situation as quite manageable compared with the profound business uncertainty companies faced during the financial crisis.

Important 'Extenders' | Provisions That Need to Be Renewed Regularly

  • Protection from alternative minimum tax
  • Enhanced charitable deductions for business
  • Business research credit
  • Ethanol subsidies
  • Biodiesel incentives
  • Faster depreciation for business investments
  • Tax deferral of overseas financing income
  • Expensing of 'brownfields' remediation
  • Charitable donation of IRA assets

Deductibility of state and local sales taxes

Bloomberg News

Catherine McGraw, center, waits to check out at a J.C. Penney store in Mentor, Ohio.

Deductibility for school supplies

Associated Press

Stacey Ressler, a teacher in Wernersville, Pa., organizes classroom supplies she purchased.

"We're used to [uncertainty] in the tax world," he says. "What's changed in the last few years is the size of the temporary extensions."

Obama administration officials note that the tax code has been through gyrations before, for example in the 1980s, when Congress adopted accelerated depreciation in 1981, only to repeal it five years later. That threw real-estate markets into an uproar and added to problems that contributed to the savings-and-loan collapse.

The White House says the current confusion points to the need for a system that is more stable and simpler. "We've got to have a larger debate about...how is this country going to win the economic competition of the 21st century," President Obama said last week. "That's going to mean looking at the tax code and saying, what's fair, what's efficient? And I don't think anybody thinks the tax code right now is fair or efficient."

Small business is often looked to as a source of job growth. But the latest monthly survey by the National Federation of Independent Business, a small-business advocacy group, found that 75% of owners felt it wasn't a good time to expand, and one in five said the main reason was doubt about policy environment, including taxes.

For smaller companies, tax uncertainty could be an incentive to expand overseas rather than in the U.S., according to Tom Duesterberg, president of the Manufacturers Alliance, a group representing medium-size firms. Companies "can't wait until all these [tax] questions are resolved," he says. "They are not going to wait until all that definitively happens. They have to deploy cash, please their shareholders and expand and grow."

Billy Hoffpauir, a developer in Lafayette, La., says he has been trying to sell some real estate because "with the current uncertainty, I am unable to quantify the risk to make long-term investment decisions." If he finds buyers, he says, he would be likely to plow the cash into "other interests, probably overseas," because some foreign countries have more favorable taxes and regulations. The tax situation is the overwhelming driver in his business decisions, Mr. Hoffpauir says.

Lea Bailes, president of Guier Fence in Blue Springs, Mo., says his plans for next year depend on how the tax debate turns out: "We're looking at acquiring a couple of smaller fence companies. The number we acquire, honestly, will depend on what we have to pay in tax."

The company, which employs about 70, would try to hire two to three new workers for each acquisition, possibly 10 in all. "If everybody our size can add 10 employees, we'd be a lot farther down the road in dealing with the unemployment," Mr. Bailes says.

Guier is in the process of acquiring another firm now, and while Mr. Bailes likes to take time to make such decisions, he worries that concern over a possible rise in capital-gains rates might make the seller push to complete the sale this year. The bill in Congress would keep the current 15% top rate for two years.

One reason unsettled rules on individual income taxes affect planning at small businesses is that many don't pay corporate tax, but pass business income through to the owners for taxation on their personal returns.

Bill Wiygul, whose family owns four auto-repair businesses in northern Virginia, estimates he and his wife would pay at least $20,000 more in various taxes in 2011 if Congress doesn't address parts of the code, including the Alternative Minimum Tax. The AMT snags a growing number of filers each year, and while Congress regularly limits the number affected—and likely will do so again this week or next—this has so far been an AMT "patch," never a permanent fix.

Mr. Wiygul says he would trade an increase in tax rates for greater certainty if the pain was shared by all. "We are petrified," he says. "We would be more actively pursuing expansion opportunities if we felt like the climate was more certain."

Large multinationals are only marginally affected directly by income-tax provisions on the table this year. Yet the stakes might be high for these companies. Executives worry about becoming a target for lawmakers seeking revenue to narrow deficits.

If a broad revision "is a true 'step back, let's take a fresh look,' we would not be frightened by that," says Ken Cohen, a vice president at Exxon Mobil Corp. But if it pits industry versus industry or becomes a hunt for revenue, "that's the process we would have much more apprehension about."

The reasons the tax code has acquired an increasingly temporary cast have to do with deficits, a divided Congress and even the constitutional system.

Political division contributes because of the daunting task of mustering a filibuster-proof 60 votes in the Senate. Legislative shepherds of the Bush cuts resorted to passage under what is called "budget reconciliation," requiring only a majority vote. But a measure passed this way can't be for longer than the budget that authorizes it, in this case 10 years. Hence the provisions expire in 2010.

Such an outcome is less likely in countries with parliamentary systems because these leave the government less subject to having its will thwarted by a large minority. "Very few countries have tax provisions that expire unless legislative action is taken," says Jeffrey Owens, head of tax at the Organization for Economic Cooperation and Development in Paris. "Also, in most OECD countries, it's the government that initiates new legislation, and once proposed the legislation generally passes."

Deficits tempt legislators to give tax provisions a temporary term to disguise their cost. For proponents of a new tax provision, the strategy is to get a foot in the door by passing it for a year or two, at a seemingly affordable cost, intending to renew it regularly.

That is how the number of provisions up for yearly extension has ballooned. Though the provisions are often extended in a bundle, a given provision's inclusion in the bundle is never certain.

Perhaps nowhere has tax uncertainty been felt more intensely this year than in the estate tax, always a controversial matter.

A 2001 law lowered its rate and increased the exemption in steps, with the tax lapsing in 2010 and then, unless Congress acts, returning in 2011 at a 55% top rate on estates of $1 million or more. The unusual hiatus coupled with a far more costly tax as soon as 2010 ended gave "just an unbelievable Alice-in-Wonderland aspect" to planning for certain well-to-do families, says Bruce Stone, a Miami-area estate lawyer.

Sales of a life-insurance policy commonly used for estate planning rose 22% in the first nine months from a year earlier, and their death-benefit coverage was up 30%. Though the policies can also be used for other purposes, part of the jump seemed clearly to be for hedging against the possible estate-tax jump in 2011.

In a few cases, the uncertainty drove people to ponder extreme measures to avoid a tax hit for heirs.

David Drouhard, a Washington-state farmer who is 56, received a diagnosis of advanced kidney cancer 14 months ago and faced a grim set of treatment choices. Most offered little chance of extending his life more than 18 months, although an immunity-boosting drug held out some hope. Mr. Drouhard says he worried that inaction on the estate tax would force his family to sell his wheat and alfalfa farm, now worth about $3 million, to pay taxes if he died in 2011.

After much deliberation, Mr. Drouhard decided to take the immunity-boosting drug, but with a caveat: "I said, 'If we don't see results from the first series [of treatments], I'm going to stop,"' he says. "I try to take care of my family, so why not go ahead and die instead of living another six months." He has responded well to the treatment, but adds: "I think it's wrong that you have to make that kind of decision."

The compromise Congress is weighing this week would set a top estate-tax rate at 35% and the exemption at $5 million.

But this would be for just two years. Just as this year, a failure by Congress to act then would cause the tax to then revert to a top 55% rate and $1 million exemption, in this case in 2013.

—Leslie Scism contributed to this article.

Write to John D. McKinnon at john.mckinnon@wsj.com, Gary Fields at gary.fields@wsj.com and Laura Saunders at laura.saunders@wsj.com

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