Sooner or Later, Big Tax Hikes Inevitable

It won't happen this year, not with elections coming up, but there's no other way to close the budget gap.

Don’t be fooled by all the tax cuts you’re going to see approved this year. Tax increases are on the horizon -- and yes, they’re likely to apply to the middle class, too. The U.S. Congress just can’t get its fiscal house in order without raising revenues. Democratic leaders will be careful to keep a lid on the tax-hike talk through the November midterm elections, but the debate over whose ox gets gored will have to begin next year.

There’s no getting around the budget hole that the U.S. finds itself in. The Congressional Budget Office recently projected that the deficit will exceed $600 billion a year for the next 10 years. And if deficits remain unchecked during that time, the total federal debt could climb to a stratospheric $15 trillion by the end of this decade. Anyone who says that a gap of that size can be plugged by cutting spending alone is either kidding or crazy.

The debate, when it comes, isn’t going to be over tax changes that nip around the edges of the IRS code. Lawmakers are going to have to raise massive amounts of revenue, and they’ll be forced to look at big-ticket items. So where are taxpayers going to take the hit? That will depend, of course, on who is in power after November. If Democrats retain the upper hand, it’s a safe bet that upper-bracket taxpayers will face higher taxes on income and capital gains. The deficit will play right into the president’s hands: He’ll use the budget gap as an argument for raising the top marginal income tax rate -- currently 35% -- to 39.6% on single folks with taxable incomes above approximately $196,000 and married couples over $231,000. He’ll also push for a top capital gains rate of 20% for this group, up from 15% now.

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Democrats could also trot out a plan for a surtax on upper income taxpayers. This idea was endorsed by the House last year during the debate on health care reform, and it would have pulled in more than $500 billion, so it’s likely to be on the table in any deficit debate. And middle-class taxpayers will probably be included as well: It’s not hard to imagine some form of payroll tax increase, since the House considered a hike in the 1.45% Medicare tax to 1.8% last year, also as part of health care reform.

What direction will Republicans go in, if they’re in charge? They’re more likely to push a consumption tax, which would hit all income levels. The huge revenue that could be raised by a value-added tax or national sales tax would look very attractive to deficit cutters. The trick, of course, would be where to set the rate. Lawmakers will want it as low as possible, say 1%, to garner votes, but they will be under heavy pressure to exempt things such as food and medicine. To offset those exemptions, the rate would have to be 3% or more.

As controversial as they are, it’s hard to see any of these tax hikes making it through Congress -- at this point. And there’s no sign that either party has the spine yet to make the tough decisions on revenues. But the budget numbers aren’t going to get any better, and they are what will finally force lawmakers into making some pretty distasteful decisions about raising taxes.

Senior Tax Editor, the Kiplinger letters