Monday, November 23, 2009

Could The Bush Tax Cuts Be Ended Early?

Yes, the government can pass tax increases that are retroactive, as demonstrated by the Omnibus Budget Reconciliation Act of 1993, signed into law by Bill Clinton. David Galland from Casey Research thinks it could happen again as the democratic majority is in desperate need of raising revenue without expending political capital. See the following post from Daily Wealth.

The administration knows its massive deficits will be poison come the November 2010 midterm elections. At the same time, it also knows if it cuts stimulus spending, it risks kicking the props out from under the recovery just ahead of those same elections.

There's only one way out. That's to boost revenues... and soon. It would be political suicide for Obama to break his pledge not to raise taxes on the middle class. So all that's left is to mug the "wealthy."

It's already a given that taxes are going up for higher income earners and investors. Most importantly, the administration and its Congressional allies have announced they'll allow the Bush tax cuts to expire in 2011. Those cuts, passed in 2001 and 2003, reduced personal income taxes and capital gains taxes, as well as eliminated the estate tax.

Once the Bush tax cuts expire, high earners will see their personal income taxes rise from 35% to 39.6%. (And probably go up from there. The House health care bill includes an additional 5.4% surtax on gross income for high-income individuals.) In addition, the estate tax will return.

And long-term capital gains tax rates, now at 15%, will be boosted to as much as 28%.

But here's the rub: Ahead of the 2011 tax changes, investors will begin dumping appreciated stocks in order to lock in capital gains and avoid paying the additional taxes. That will create an unwelcome stock market selloff ahead of the November 2010 elections.

The Democrats knows this, which is why – behind the scenes – they are now setting a bulletproof tax trap to spring soon after the New Year begins. The trap is simplicity itself: a repeal of the Bush tax cuts in 2010, a year ahead of schedule.

Further, when passed, the legislation will be retroactive to January 1, 2010.

It's the perfect trap, because once the higher taxes are in place, there will be no tax incentive for anyone to divest their shares. In fact, many people will decide to hang on to their stocks until a more investor-friendly regime returns to power.

By increasing taxes across the board on the wealthy a year ahead of schedule, the government gets a big lift in revenue. Simultaneously, it avoids a rush for the exits that would otherwise occur ahead of the capital gains tax increases. For the government, it's a win-win. Very much not the case for investors.

Could the government really pull this off – implementing a retroactive tax increase?

In a word, yes. Back in August 1993, President Clinton passed the largest tax increase in history – the Omnibus Budget Reconciliation Act of 1993 (OBRA) – and made it retroactive to January of that year.

It was challenged in court, and the court held that retroactive tax increases were legal. This was not the first time this sort of chicanery had been pulled. (You can read more on the topic of retroactive taxes by clicking here.)

Why am I so confident this trap is being set? Nancy Pelosi herself tipped her hand on the retroactive tax plan when she said last January she wanted Congress to repeal Bush's tax cuts well before their scheduled expiration date. An early repeal of the Bush tax cuts was also one of President Obama's campaign promises.

The administration and its allies have since gone quiet on its intentions. But that's only because they want to avoid triggering a stock selloff before the end of 2009. That all changes once the ball drops in Times Square this coming New Year's Eve. At that point, it will be too late to escape.

The good news is that avoiding this trap is as easy as selling your most profitable stock positions on or before December 31, 2009. This way, you'll only pay 15% on your long-term capital gains... instead of the 28% the government is planning to sting you with once its tax trap is sprung in 2010.

You've been warned.

This post has been republished from Daily Wealth, a contrarian investment site.

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