November 24, 2005
Thursday

The first rule in government, as in medicine, is the Hippocratic one: Do no harm. Unfortunately, Congress is about to do severe harm to the U.S. economy if it fails to act in the next few months to stop three huge automatic tax increases.

Let me shift metaphors. The increases - 133 percent for the rate on dividend income, 33 percent for the rate on capital gains and what amounts to an infinite increase in the coming rate on what you pass on to your heirs - comprise a ticking time bomb.

The dividend and capital gains rates were reduced to 15 percent in 2003. The estate (also called death or inheritance) tax got an overhaul in 2001, with gradual reductions over 10 years and complete elimination set for 2010.

But the dividend and capital gains cuts turn into pumpkins (reverting to their old top rates of 35 and 20 percent, respectively) at the end of 2008. And in 2011, the pre-2001 estate tax reappears. Since backers lacked 60 Senate votes, all three of the cuts were only temporary.

The estate-tax cut can wait a bit for an extension, but the dividend and capital gains tax cuts can't. My guess is that, early in 2006, the prospect of the big increases will weigh on markets. Investors will start selling stocks and other assets to take advantage of the expiring 15 percent capital gains rate, driving down prices.

Academic research has found that the dividend cut, by increasing what America's 57 million investing families can keep after taxes, boosted stock prices considerably. A paper for the prestigious National Bureau of Economic Research by Alan Auerbach and Kevin Hassett concluded that the cuts "had a significant impact on equity markets" - a broadly positive impact. Take the cuts away, and stocks will almost certainly head in the opposite direction.

As for the estate tax: It's hard to say if the tiny changes so far have had an effect, but the elimination of all taxes at death certainly will. Surveys show the estate tax is the most broadly despised federal tax, hated even more than the income tax. Americans of both parties think it's unfair to tax income once on receipt and again at death.

A good compromise - one that would likely have become law if it weren't for the post-hurricane political meltdown - would have been to exempt, say, the first $5 million of an estate from all taxes (a figure that would be indexed to inflation) and tax the remainder at 15 percent.

That's the golden number: 15 percent. It's low enough that -for income and investments - it doesn't get in the way of people's decisions about working hard, saving and investing more and generally doing the right thing economically.

There's not the slightest doubt that the tax cuts enacted in 2001 and 2003 (including those on personal income) played a big role, along with low interest rates, in keeping the recession short and shallow and in keeping the U.S. economy the most robust in the world. Today, we're growing at better than 3.5 percent, compared with about 1 percent for Germany and France. Our unemployment rate is about half theirs.

But what about the budget deficit? It's a non-issue. First, the deficit is small (2.6 percent of our $12 trillion-plus GDP), and it has had no effect on interest rates or the value of the dollar, which, despite Warren Buffett's prediction (which cost his company a billion bucks), has risen strongly in 2005. Second, America's fiscal problem is too much spending. The problem is, emphatically, not the way that the funding for that spending is allocated, between taxes and borrowing. At these low interest rates, we should, in fact, be borrowing even more.

In a perfect world, an extension of the Big Three cuts could be part of comprehensive tax reform, along the lines recently recommended by the Mack-Breaux Commission. Let's end tax breaks on real estate, health insurance, state taxes and other preferences and lower all rates to the 15 percent level. Then we'd see fantastic economic growth in America, just in time to engage surging China, India and Japan.

But I'd settle for a simple Hippocratic move: extend the dividend and capital gains cuts by April, then force a vote on an estate-tax compromise just before the 2006 elections. Defuse the ticking time bombs.

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