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

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

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?

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.

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:

•Switching out of stocks of dividend-paying companies to other more tax-favored issues, such as municipal bonds;

•Obtaining a bigger mortgage than originally planned to get a larger mortgage interest deduction;

•Retiring from work, perhaps earlier than planned. Or, if a household has two wage earners, one quitting his or her job to trim taxable household income.

•Opting not to start a small business.

Other experts don't expect major economic harm from higher taxes.

"Unquestionably, people will undergo a reasonable amount of tax avoidance in response to higher taxes," says Ben Harris, a senior research associate at the Brookings Institution, a Washington think tank. But he doesn't expect tax avoidance to be "so drastic that tax collections will decrease dramatically or that people will take a lower salary or stop investing."

Harvard economist Raj Chetty's estimates of long-term tax avoidance are not far from Carroll's: a 3 percent income drop for every 10 percentage point rise in tax rates. But he doesn't find that such avoidance causes broad problems.

"People have overstated the cost of raising taxes on the rich," he says. "The net effect is simply too small to show up in the economy.... GM will not produce fewer cars. Microsoft will not produce less software. Although CEOs might reclassify some income, this doesn't affect the GDP [gross domestic product]," Mr. Chetty says.

What's more, the highest marginal tax rate proposed by the Obama administration still pales in comparison with earlier top rates, some experts note. For instance, in 1944 and 1945, the top federal rate was a whopping 94 percent. Between 1971 and 1980, the highest federal rate stood at 70 percent, according to the Internal Revenue Service.

Average tax rates headed up

Of course, these marginal rates don't reflect the rate high earners pay on all their income. The more telling number is their average tax rate.

"Right now, the top 1 percent of taxpayers probably pay about a 27 to 28 percent average federal tax rate" versus the current 35 percent marginal tax rate, Mr. Giertz says. That average rate could rise to 34 or 35 percent if the Obama tax plan goes through and new Medicare taxes take effect in 2013 under the recently passed health-care law.

Add in-state and local taxes, and the "average tax rate on the top 1 percent of taxpayers could hit about 50 percent," even without the new health-care taxes, says Giertz. The rate would be even higher in high-tax districts like New York City and lower in places with no state income taxes, such as Texas.

Even these rates aren't horrific compared with some levels in the past. If the Obama plan passes, Giertz says, the top 1 percent of taxpayers would be paying "a decent amount" less than they did in the 1960s and '70s.

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