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When taxes rise next year, will the rich avoid them?

Extreme tax avoidance could frustrate Obama's plans to trim the deficit.

By Margaret PriceCorrespondent / June 10, 2010

Next year, when wealthy Americans fill out their Internal Revenue Service tax forms, they're likely to be hit with higher taxes. How much tax avoidance will they engage in for the long term?

Karen BLEIER / AFP / FILE

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If tax rates on the rich rise next year, as the Obama administration plans, millionaire Eric Schoenberg of New Jersey will gladly pony up. "Many of the wealthy are aware of the budget deficit. And they're willing to do their fair share to correct it," says Mr. Schoenberg, a Columbia University economics professor whose wealth comes from investments and inheritance.

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It's a noble sentiment. However, when rates have gone up in the past, most big earners have looked for ways to avoid more taxes, not pay them. As the 2001 and 2003 tax cuts sunset this year, the key question is how much tax avoidance rich Americans will engage in this time around – and for how long. If they shield too much income, they'll frustrate the Obama administration's efforts to trim the deficit by raising taxes on the rich.

"The rich will not leave money on the table because of a sense of social responsibility to help finance the government this year," says Seth Giertz, an economist at the University of Nebraska at Lincoln. If tax rates rise on the rich, he's expecting the "usual response" by high earners of shifting income to the lower tax year.

The rich typically avoid tax increases in the short term, experts agree. The last time federal income taxes rose on upper-income earners – in 1993, when the highest rate climbed to 39.6 percent from 31 percent (and a 33 percent rate was created) – about $20 billion of wages were shifted to 1992 from 1993 to avoid the higher tax in 1993, reports Robert Carroll, senior fellow at the Tax Foundation, a think tank in Washington. The moves trimmed tax receipts the government would otherwise have expected by some $1.5 billion, Mr. Carroll estimates.

Where the debate has raged is over the long-term effects. Ever since the so-called Laffer Curve became popularized in the 1970s, some economists have held that taxing the rich is counterproductive.

While the long-term effects are one-third to one-half the size of the short-term impact, they're still significant, Carroll holds. "Year after year, the higher rates reduce taxable income about 3 percent – lowering revenues the government would otherwise expect from the higher rates by upwards of 40 percent."

Obama plan: Tax the rich

Rather than letting the Bush-era tax cuts expire at the end of this year, which would raise rates for most taxpayers, President Obama proposes raising only the top two federal income tax rates to 39.6 percent from the current 35 percent and to 36 percent from 33 percent next year. These moves would apply to households with at least $250,000 of gross annual income – and individuals making at least $200,000.

If the Obama tax plan passes, some experts foresee several moves for high earners:

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