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The Morning After: The Tax Deal Hangover

December 8, 2010 · 36 comments

I’ll admit that I didn’t see yesterday’s tax deal coming. I was fairly certain that the drama would play out through this week. We still have drama but now it’s more of the “let me explain” variety.

Let me see if I can sort out for you what happened and why.

First, let’s talk timing. Almost across the board, the extensions are for two years. That wasn’t a random number. It directly coincides with the next important set of elections: at least 1/3 of Senate seats are up for grabs, about 1/5 of gubernatorial seats will be at issue and, of course, it’s the next presidential election. So very, very calculated.

Second, let’s talk politics. This was a big win for the GOP. Huge. President Obama structured the deal, it appears, solely to gain unemployment benefits for yet another year (actually, the benefits are extended for 13 months). This was a fairly significant priority for the Democrats but politically, not very smart. Benefits have been extended seven times since 2008. Yes, folks are unemployed. While I am extremely sympathetic to the plight of those who are without jobs, I don’t think that unemployment benefits are an appropriate bargaining chip in a comprehensive tax strategy. Making the whole thing even worse? The GOP is making noise this morning (now that they know how much power they have over this Congress) about not approving the unemployment benefits after all. Yeah.

Third, the cost. The cost of extending the cuts was enormous to begin with. The Treasury set the cost of simply extending the cuts at $3.7 trillion over 10 years. That would make a two year cut would be $740 billion. But the deal goes beyond that. You have to figure in the federal estate tax provisions (see below), the payroll tax holiday (also see below) and more. I feel like an informercial spokesperson but… we’re not done yet! Now throw in the unemployment benefits extension. Yep, we’re at billions. The Dems look foolish as they were unable to stop piling on the tax breaks – it’s all very Oprah again, isn’t it? You get a tax break! And you get a tax break! Especially at the top. And the GOP should be ashamed of themselves. They promised not to let this happen. Where is the fiscal responsibility here? There is none.

So basically, everyone gets something in this deal with those at the top and those at the bottom getting the most benefit (of course). It will cost us billions. Initial estimates are at – hold onto your hats – $900 billion. And we’ll be back in the same darn boat in two years. This is supposed to be progress?

Enough with my ranting (ok, spoiler alert, there’s more below). Here’s a synopsis of the various components of the deal:

  1. Federal Estate Tax. I didn’t see this one coming at all. I predicted a freeze to the 2009 rates ($3.5 million personal exemption and 45% top tax rate). But apparently, it’s 1931 all over again. That’s because the rates will top out at 35% – the lowest since 1931 – with a whopping personal exemption of $5 million per person. It’s effectively a repeal for most Americans since, with a little bit of decent estate planning, a married couple can pass $10 million to their heirs without being subject to the tax.
  2. Individual Income Tax Rates. They aren’t going anywhere for the next two years. The same rates created under EGTRRA will stand. In other words, the effective marginal tax rates for 2010 are the same ones you’ll see in 2011 and 2012. Rest better. You’ve all avoided a 3% hike – for a family making $50,000, that means you’ve avoided a $1,500 bump in tax for 2011.
  3. Alternative Minimum Tax (AMT). We got our patch. I haven’t seen the numbers but I’ve been told that it’s similar to the 2009 numbers for 2010 and 2011. No word on 2012 and beyond. Congress estimates that a mere 23 million taxpayers will be affected by the AMT in 2010 instead of the projected 44 million taxpayers. I guess you can call it progress. But would it be too much to ask that we get some real relief? Some day?
  4. Capital Gains Rates. This was the sacred cow for much of the GOP tax strategy. Lower capital gains always, always means heightened investments and a better economy. Always. It’s worked so far, right? Cause we have the same rates for the next two years (meaning a top rate for long-term gains of 15%).
  5. Dividends. Same story as on capital gains rates: current rates are extended.
  6. Payroll Tax “Holiday.” With the administrative nightmare that was the Making Work Pay Credit gone, we needed a little something else to challenge preparers and the IRS. Enter the payroll tax “holiday.” It’s a one year (just one, not two like much of the other provisions) cut in Social Security taxes for workers. For 2011, you’ll pay in 4.2% on the first $106,800 of wages rather than 6.2%. That means a 2% cut so that a worker earning $50,000 would pay $1,000 less in 2011. But only for 2011. Good luck employers, preparers and the IRS in figuring that one out.
  7. Child Tax Credit. I’ll be honest. I expected to see this one go, too. The child tax credit is a darling of the Dems but always a thorn in the GOP’s side. You know, the whole stereotype of mothers having kids just to get tax benefits (as a mom, I roll my eyes at this idea but there you have it) has always been a reason to limit credits attached to children; of course, there’s also the more rational, understandable concern that having children should be a tax neutral event (this, I get). The child tax credit had been bumped under Bush to $1,000 per child with a $3,000 earned income floor to make it refundable. That will stand for the next two years.
  8. Earned Income Tax Credit (EITC). Show of hands: who expected this to be extended? The EITC is probably the most controversial of the tax credits. The tweaks under EGTRRA expanded the base of low to middle class families eligible for the credit, which cost taxpayers $42.9 billion in 2008. I assumed that the GOP would shrink this one back to its pre-2001 levels and allow the eligibility cap to increase. That didn’t happen. The EITC base remains the same as for 2010.
  9. American Opportunity Tax Credit (AOTC). Yawn. We heard all about how great this extension was from Obama, who pushed hard for the renewal. It’s a gimme. The modified version of the Hope Credit allowed a slightly bigger credit ($2500 versus $1800) for students pursuing a degree. And who’s going to vote no on tax credits for college students?
  10. State and Local Sales Tax Deduction. The option to deduct sales and local sales taxes on your federal income tax return – even if you don’t itemize – ended in 2009. Rumor has it that the new tax deal brings the deduction option back, retroactively, so that it will apply to 2010 and 2011.
  11. Transfers of IRAs to Charities. Also rumored to be in the plan? The option to allow those taxpayers over the age of 70-1/2 to roll their IRAs directly to charity. If true (and I have it on decent authority that it is), that would also be retroactive.

So that’s the summary of what’s in the tax deal (allegedly – remember, the ink isn’t dry yet). So what’s missing?

  • Elimination of the Home Mortgage Interest Deduction. Realistically, I didn’t expect this to be tinkered with this year but there was a lot of noise made about it last week. It’s still there, big as always.
  • Making Work Pay Credit. It’s gone for 2011 which is probably a welcome sight for many tax preparers (that Schedule M was a bear). There was some initial confusion on this one with rumors that it had been included in the deal. That turned out to be wrong. It was “replaced” with the Payroll Tax Holiday (see above).
  • Lower Medical Expense Floors. There was some talk about a lower floor for medical expenses following the passage of the health care plan. Come tax talk time, nary a peep. So it stays at 7.5%.

Whew. That’s quite the summary. And it could all change in an hour. But this is what the plan is as of this morning. There’s a lot of criticism over the package – expect something to change. I just don’t know what that something will be. Any guesses?

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{ 27 comments… read them below or add one }

1 Kara December 8, 2010 at 9:36 am

Great summary!
I am with you – completely caught off guard by the Estate Tax exemption and rate. With these numbers, educating on the importance of planning will remain challenging.
Note to self: Remove Payroll Preparation from my list of services this morning.

2 Kelly December 8, 2010 at 9:41 am

Thanks Kara.
Exactly my point on the estate tax. It will give folks a false sense of security since it feels so much like the 2010 “repeal” with those numbers. But there’s no permanency which makes it so frustrating for planners.

3 Brash Tax December 8, 2010 at 10:42 am

Good summary, TG. I think you understate the impact of the rates as a potential 3% hike. Indeed tax rates would have risen three to five percentage points. That translated to 10-50% increase in actual taxes. A $1,500 tax hike for a couple making $50,000 is huge, not to mention the child credit adding another $2,000 if they have a couple of kids. That same couple will get another $1,000 with the payroll tax cut next year. $375 a month is probably the groceries for this family.

What’s weird to me is how so many people look at this like budget analysts. Maybe Americans really do care about the deficit. But if you the average American worker looking at his paycheck, or business looking to hire, there are only a couple of new things here. The payroll tax cut and business expensing.

Interesting that politicos keeping score call these Obama victories. Granted, the president may have traded in the Making Work Pay Credit for the payroll tax cut but this is an across the board tax cut. It’s got a ceiling but in contrast to the MWP credit, everyone over $106,000 gets $2,000. It’s not a credit so it’s not a government check like MWP. Two things bother me. That’s money that supposed to be going to Medicare and Social Security. This is no way to address the nation’s fiscal problems. Secondly, it’s temporary. I’m not saying it should be permanent but, politics and deficits aside, we just have to stop adding temporary policies into the tax system.

Which brings me to 100% business expensing. This is pro-business Republican economic policy on steroids. And it’s Obama’s baby. Look nothing wrong with helping business write off capital purchases a little faster. But what do you think is going to happen next winter. Business will buy equipment like there’s no tomorrow and stop spending on January 1, 2012 and the economy will feel like a crack head going through withdrawals. (Not to mention payroll taxes will rise and unemployment benefits will expire.)

4 ryan yin December 8, 2010 at 10:51 am

You know, the whole stereotype of mothers having kids just to get tax benefits (as a mom, I roll my eyes at this idea but there you have it) has always been a reason to limit credits attached to children; of course, there’s also the more rational, understandable concern that having children should be a tax neutral event (this, I get).

I confess I’m a bit confused by the above. If you think the child tax credit has zero effect on behavior, then why does it matter whether it’s a tax neutral event? If it doesn’t change what people do, it’s the perfect form of redistribution (subject to your distributional preferences, of course) — zero deadweight loss, right?

5 Joe December 8, 2010 at 11:48 am

Under #6, should “For 2010, you’ll pay in 4.2%” say 2011, or should we be expecting a refund of some of our social security withholding from this year?

6 Rich Hofmann December 8, 2010 at 11:51 am

You missed a big piece of the package: the ability for business to expense capital purchases in 2011. This is a HUGE incentive for businesses that have been hoarding cash to put it to use through expansion and may be the single item that might actually provide significant economic stimulus.

7 Jennifer Stiller December 8, 2010 at 11:56 am

Thanks, Kelly!

One question — Do those of us who pay the self-employment FICA tax get any benefit from the Payroll Tax Holiday?

8 Tom December 8, 2010 at 12:00 pm

Is there any word on the fate of the Energy Property Credit which is due
to expire at the end of 2010?

9 AK December 8, 2010 at 1:01 pm

@BrashTax “Interesting that politicos keeping score call these Obama victories.” That’s odd, because I follow opinion news closely on both sides (call it masochism if you will), and from what I’ve seen, the left politicos seem pissed at Obama for considering compromise, while the right politicos seem to see this as congress “successfully rejecting the Obama tax hike”.

The crazy thing is that DeMint just came out and asked “how are we going to pay for the unemployment extension?” Selective responsibility, I guess.

10 TexasEd December 8, 2010 at 1:19 pm

Thanks for the summary! I have two concerns. First, this is not a tax cut — you might call it an extension of tax cuts, but it was only a cut when it (they) was/were enacted. Now, it’s a continuation of the status quo.

Second — the cost. I’m not a financial expert, but in my opinion, there is no cost. To call this cost, you must assume the funds are the government’s in the first place, which they are not. And, you must also assume the economy is a zero sum game, i.e., there will be no increases in nationwide income which would produce more tax revenue even with lower rates.

Personally, I think any time you reduce the government’s revenue, it’s a good thing. The real problem here is spending!!

11 Brash Tax December 8, 2010 at 1:31 pm

@AK I see your point. In terms of the negotiation process and who got what, a lot of folks are saying Republicans “got” upper income tax rates and estate tax. In exchange, Obama “got” UI, tuition credit, child credit, EITC, payroll tax cut and business expensing. In my view UI is appropriate (GOP is opposed). tuition, child and EITC are all existing programs expanded by Obama but also expanded by Bush. Not much support among Republicans but small potatoes. Payroll tax cut in exchange for Making Work Pay is a big loss for Dems. And business expensing is great for big business. Add it all up and Republicans “got” a great deal in exchange for an extension of unemployment.

12 Michael J Craig, E.A. December 8, 2010 at 3:15 pm

Awesome summary!!! Way to go TAXGIRL!!!

13 Kelly December 8, 2010 at 3:52 pm

Thanks Michael!

14 Kelly December 8, 2010 at 3:54 pm

It’s semantics, of course, and I get your point, but as it’s temporary, I think you can still call it a cut – just an extended cut. ;)

15 Kelly December 8, 2010 at 3:55 pm

Tom, I don’t know. I’ll keep looking.

16 Kelly December 8, 2010 at 3:55 pm

Jennifer, my gut would be yes – but let me read the fine print. I haven’t seen the actual wording yet.

17 Kelly December 8, 2010 at 3:56 pm

Rich, I was going to do a separate posts on business breaks… There’s also the R&D credit, etc. I wanted to focus on individual taxes. But I promise I’ll include it! Thanks for noticing.

18 Kelly December 8, 2010 at 3:57 pm

Joe, totally a typo. For 2010, you still have the Making Work Pay Credit. For 2011, payroll tax holiday.

19 Cassie December 8, 2010 at 10:47 pm

How lovely this year to know that soon enough, I could look to TaxGirl for an understandable, comprehensive and even enjoyable! summary of what’s going on (even as it morphs beneath our feet). Thank you ! When are you going to run for Congress?!

20 Russ DeMott December 9, 2010 at 5:39 pm

Great summary of these developments. Your blog is outstanding. I found it on the ABA website.

21 Kelly December 9, 2010 at 5:41 pm

Thanks Russ! I appreciate that very much!

22 Brad December 12, 2010 at 4:29 pm

Did you see the gift tax? It’s reunified with the estate tax so that each person can now transfer $5 million through 2012! Wow!

23 HERB December 16, 2010 at 5:37 pm

Hey Tax Lady:

You said there is something for everyone in all of this mess! WRONG! WRONG! WRONG! What about us U S citizens who worked and worked and worked for years paying into Social Security and have no income other than Social Security, what about us? There is no increase of any kind, nothing for us, totally nothing. What happened to that 2% or 3% increase in our income we used to look forward to and depend upon each year to help us get by on. It is GONE, GONE, GONE! I see no possible improvement improvement next fall and it will be GONE again. Do not any of those jar heads sitting in congress realize that we as retired citizens paid into this so called retirement fund called Social Security every working day for the past 30 or 40 years. The governments solution is the more of us that die before we can draw out of our Social Security the better. Every penny I put into my Social Security was matched by my employers, the least the government could have done was applied some interest to our accounts, heck no. Now when the economy is basicly screwed up we have to do without and beg to get any type of an increase for OUR money. Thank God for AARP helping once in awhile to remind the government we, us over 66 are still alive. Enough said, you get the point! Not everyone is getting something!

24 HERB December 16, 2010 at 5:49 pm

TaxGirl:

Love your web site. I just discovered it and signed up for daily info and stuff. I totally love the way you seem to be able to put your writing in such a way that everyone can understand what is going on and why it is going on.

This is great, and please keep up the great work and effort.

25 Kelly December 17, 2010 at 3:15 pm

Thank you Herb!

26 Kellen December 17, 2010 at 4:43 pm

Herb, you may have paid in every day for the last 30 to 40 years, but your money has probably already been borrowed years ago and spent by some administration or another.

Maybe if we all have a TON of kids, they can pay for our social security checks later on??

27 Melody January 1, 2011 at 5:40 pm

Kelly,

Thanks so much for the fine summary! I’ve been out-of-the-loop for a few months (busy, computer crashed and burned, etc). I haven’t really seen a good summary of what’s in this package — and I need to know, since I’ll be preparing taxes next year.

In terms of what this does to the IRS (and us tax preparers), it’s scramble time! AARP starts the first week in February — I hope I don’t get anyone at my sites who needs to itemize for a month or so!

Melody

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