All's Quiet on the Economic Front, But a Storm Is Brewing

Almost 90% of likely voters consider the economy an important election issue, yet the economy isn't getting much attention this campaign cycle.¹ In the 2004 presidential and 2002 mid-term elections, the national economy took center stage. But most economic issues in this cycle have been at the local level, playing a critical role in only about two dozen House races.²

With the Dow Jones Industrial Average hitting record levels this year, energy prices recently trending downward, interest rates leveling off, unemployment still low, and Social Security reform apparently dormant for now, we could be entering a relatively quiet period for legislation and political rhetoric related to the economy and personal finance.

However, because of congressional budget rules, most tax laws coming out of Washington have sunset provisions, and 2010 is when the sun goes down on many of the tax cuts enacted since 2001. Over the next few years, Congress will have to decide whether to extend the current rates or allow them to expire. Because tax rates in the United States are set by elected officials, these tax-law provisions are certain to become political issues between now and 2010.

Income taxes: Legislation that passed in 2001 created the 10% marginal income tax bracket and set in motion a gradual reduction of all other federal marginal income tax rates. Legislation passed in 2003 accelerated the tax-rate reduction schedule to levels that were not to have taken effect until 2006.

Under current law, the federal marginal income tax rates for 2006 through 2010 are as follows: 10%, 15%, 25%, 28%, 33%, and 35%.

The lower income tax rates and the 10% bracket are slated to expire after 2010. If no legislation extending these lower rates is passed, marginal income tax rates will revert to their pre-2001 levels: 15%, 28%, 31%, 36%, and 39.5%.

Capital gains and dividend taxes: Since May 2003, long-term capital gains and dividends have been taxed at a maximum 15% rate. These lower tax rates were slated to expire after 2008 but received a two-year extension this year. Unless another extension is passed or these rates are made permanent, in 2011 they will revert to levels that were in effect prior to May 2003. This means that long-term capital gains would be taxed at a maximum 20% rate and dividends would be taxed as ordinary income.

Alternative minimum tax: Each year for the past several years, Congress has passed temporary measures designed to help middle-income taxpayers avoid the growing reach of the alternative minimum tax (AMT). The most recent measure, passed in May, provides AMT relief for the 2006 tax year only. The new exemption levels are $62,550 for joint filers and $42,500 for single filers. Also extended was a provision that allows some taxpayers to claim many nonrefundable personal credits to offset AMT liability. These include the dependent-care credit, the credit for the disabled and elderly, the credit for interest on certain home mortgages, and the Hope and Lifetime Learning credits for certain education expenses.

Congress created the AMT in response to public outcry over a cadre of wealthy Americans who paid no income taxes in 1969. The AMT was designed to take effect when a high-earning taxpayer took advantage of multiple income tax deductions.

An increasing number of Americans need no introduction to the AMT. Because the tax is not indexed to inflation, each year more American taxpayers are either subject to the AMT or close enough to require them to make the calculation when preparing their tax returns.

Legislators from both sides of the aisle have agreed that the AMT is unfair and should be eliminated because it hits taxpayers who hardly fit the profile of wealthy Americans for whom the tax was intended. But there has been debate over how Congress would replace the $800 billion in tax revenues that the AMT is expected to bring in over the next 10 years.³

Estate tax: The 2001 tax law, which gradually increased the amount of an estate that is exempt from the federal estate tax and gradually reduced the top estate tax rate, is set to expire after 2010. The exemption limit rose from $1 million in 2001 to the current level of $2 million and is scheduled to top out at $3.5 million for estates that transfer in 2008 and 2009. The top estate tax has gradually fallen from 55% in 2000 to the current rate of 46%. It will fall to 45% in 2007 and remain there until 2010, when the federal estate tax will be fully repealed.

Unless Congress votes to extend the repeal beyond 2010, the federal estate tax will return in 2011 at 2001 levels: a $1 million exclusion and a 50% top rate. In 2006, an attempt to permanently repeal the estate tax did not make it out of the House. Congressional observers say the issue is likely to reemerge after the election. Some observers speculate that a possible compromise could include a $5 million exclusion limit and a tax on amounts above this limit at rates ranging from 15% to 30%.⁴

You may not be hearing much about the economy or taxes right now, but you will soon. Whether the lower tax rates that have been in effect for the past several years should be made permanent or allowed to expire is certain to be the subject of political rhetoric and debate in the next few years.

The information contained in this article is not written or intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from your own tax or legal counsel. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.

1-2) Associated Press, October 23, 2006
3-4) InvestmentNews, October 16, 2006