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Be Prepared: Tax Increases Are Inevitable

As April 15 approaches, MoneyWatch is publishing daily tax tips. See the full list here, and please check back frequently for the latest advice from our experts.
When consulting with a tax adviser, it is helpful to have a sense of how taxes might change in the future. My tip is about the types of tax changes that might occur in the next few years and beyond.

Federal, state, and local budgets will all come under considerable pressure in coming years. At the federal level, the main long-run problem is the growth in health care costs. If health care costs increase as projected, the cost of Medicare will increase at an unsustainable rate (Social Security can be fixed with relatively minor tweaks). In the short-run, the main problem will be paying for the stimulus package, and it's not yet clear how this will be accomplished, though some immediate changes that are already planned are noted below.

At the state and local levels, rising health care costs will also create budgetary pressures. State and local governments fund some health care programs, and state and local governments also pay for medical benefits for their employees. There are also pressures from revenue losses and increased program demands during the present recession. But the main factor at the state and local level will be finding a way to pay for promised retirement benefits.

It won't be possible to solve the budget problems through cuts in spending alone; at some point government at all levels will need to find additional sources of revenue. Thus, taxes will increase. It won't happen right away, since increasing taxes now could hurt the recovery from the recession and the economy will need to be on firmer footing before taxes can be increased. But there will come a time in the not too distant future when both the rates people pay and the tax base to which those rates apply will be increased. The only question is how the additional revenue will be generated. Here are some thoughts:

Income taxes: I don't expect income taxes to increase at the lower and middle income levels, but the same cannot be said for higher levels of income. The latest news suggests that the Bush tax cuts are likely to be allowed to expire at the end of this year for households with incomes over $250,000 ($200,000 for individuals), but tax cuts will be retained for incomes beneath this threshold. Over the longer run further increases, particularly at higher levels of income, are likely.

Capital gains and dividend taxes: These taxes are unlikely to change much. There is a belief among both liberals and conservatives that capital gains and dividend taxes are highly distortionary, so increases in these taxes are unlikely. The need for revenue makes decreases unlikely as well. Thus, it's likely that the focus will be on other types of taxes. However, it is possible that some types of compensation that are currently classified as capital gains, e.g. the income of some participants in the financial industry, could be reclassified as ordinary income and subject to higher rates of taxation.

Payroll taxes: Payroll taxes could increase modestly as one means of partially funding higher demands from social programs. The most important immediate change to consider is that the annual limit on Social Security contributions could be raised. I think it's more likely that the age of eligibility will be increased, but even so lifting the cap on contributions to Social Security could be part of the solution. In the longer term, it's also possible that health care will be partially funded through increased payroll taxes. There is already movement in this direction, but that is highly speculative.

Value added taxes (VAT): In Europe, a value added tax has proven capable of generating considerable revenue, and it is difficult to evade. It is essentially a flat tax, and hence regressive, but if the revenues are used to make substantial transfers to those at the lower end of the income distribution, then the overall effect can be quite progressive. That is how it works in Europe. I don't expect this tax to be implemented anytime soon, but as pressures mount it may come under consideration since it has features that are attractive to both sides of the political fence (e.g it is flat, which is attractive to the right, and it generates considerable revenue which helps to fund social services favored by the left). I don't think the chance of this being implemented is anywhere near as high as 50-50, but it is a possibility.

Sales taxes: As state and local governments come under more and more budgetary pressure, sales taxes are likely to slide upward. However, these taxes are already relatively high and politically unpopular so there is not much room to move in this direction. A federal sales tax is another possibility, though only in the long-run, and I would expect a VAT to be used instead.

Corporate taxes: Corporate taxes could be increased, but arguments about international competitiveness will put a tight lid on what can be done here. Thus, substantial increases are not likely. However, it is possible that loopholes allowing multinationals to transfer corporate income to countries with low tax rates will be closed, and that other means of escaping taxes will be foreclosed as well.

Property taxes: After the long, hard battle to reduce property tax rates, this will be a difficult area for state and local governments to use as a source of additional revenue in the future. Nevertheless, they will try and some increases are likely, but nothing substantial.

Inheritance taxes: There is considerable uncertainty in the short-run. The estate tax is scheduled to increase at the end of 2010 after a one year exemption, but it is not clear by how much. The latest proposal is for a $5 million exemption and a 35 percent rate, but it has not yet been enacted. Over the longer run, I expect estate taxes will edge up further, though not by a substantial amount, perhaps to the mid-40 percent range.

Financial transactions tax: A small financial transactions tax could generate significant revenue and, by slowing the transactions velocity in financial markets, reduce the chance of bubbles. This is a possibility in the long-run as budget pressures in the U.S. and other countries mount over time, particularly given public sentiment toward the financial industry. But I don't expect this to happen anytime soon.

Tariffs: I don't believe there will significant changes in the degree to which we apply tariffs to imported goods. If anything, I expect tariffs to fall. The wild card here is the trade relationship between the U.S. and China, but it's not in the interest of either country to create significant problems.

Other fees: Fees for license plates, driver's licenses, entrance to national and state parks, fees for government-run museums, public swimming pools, etc. are all likely to rise as governments look for ways to generate additional revenue.

Update: In comments, I was asked about tax revenue from programs designed to reduce greenhouse gases:

Energy Taxes: Good question on the carbon tax. I think a cap and trade arrangement is most likely, a carbon tax or any variant of such a tax would have less political appeal, but that still means higher energy taxes for consumers.

The revenue from cap and trade would come from auctioning the carbon permits, and that revenue could be fairly substantial. But I expect a lot of it will be used as transfer payments to help those who are hurt the most by the higher energy prices (e.g. lump-sum transfers). In addition, in the short-run many of the permits will be given away rather than sold, so the revenue won't be very large.

Thus, on net -- the revenue minus the compensating transfers -- I don't expect this to be a significant source of additional net new revenue, but it could certainly contribute.

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