It’s July 14th, 2010. There are approximately 30 legislative days before the fall elections and less than six months before huge portions of the tax code expire, so it’s only appropriate that today, the Senate Finance Committee held the first substantive hearing on the implications of allowing the Bush tax cuts to expire. Some key points:

  • Chairman Max Baucus (D-MT) clearly takes a dim view of flow-through taxation for certain firms and appears dismissive of arguments that higher rates will hurt the business community and employment. Washington Wire readers are encouraged to watch the hearing and see for themselves, but it’s obvious that we have lots of work to do in defending the basic S corporation structure.
  • Dr. Doug Holtz-Eakin alone made the point that as long as federal spending was too high — well above historic norms already, with the explosion in entitlement spending still before us — and until it is addressed, tax policy is going to be an exercise in second-best options.

In one “laugh out loud” moment, Professor Len Burman pointed out that higher tax rates may increase entrepreneurship because business owners have access to more deductions. In other words, let’s raise taxes because that will encourage taxpayers to come up with novel ways to avoid paying them?B Being entrepreneurial in your tax avoidance is not the sort of entrepreneurship we’re looking for here.

Perhaps the best point of the hearing was made by S-CORP ally Dr. Holtz-Eakin, who, in a back-and-forth with Chairman Baucus, made the case for flow-through taxation as cogently as anybody to date. Boiled down, his point is that because individuals pay all business taxes anyway, it makes good policy sense to tax business income at the individual rates directly.

So what to conclude? The list of witnesses and tone of the majority–especially the Chairman’s–suggest this hearing was designed to lay the policy predicate for higher rates next year. What’s unclear is exactly which taxes the Committee plans to raise. Despite what you might read, most of the Bush tax cuts enacted in 2001 and 2003 went to middle- and low-income Americans, not the rich. So the pending tax hike is going to impact regular families in a very real and harmful way. With just 30 days of legislative session left before the elections, even a well intentioned effort to extend those tax policies may fall short.

Perhaps more importantly, the hearing demonstrated the lack of a plan for what happens beyond 2010. Even if Congress extends some or all of the 2001 and 2003 tax cuts, something more comprehensive is needed if the United States is not to follow Greece down the path towards the third world. Senators Ron Wyden (D-OR) and Judd Gregg (R-NH) have introduced what they describe as a budget neutral tax reform plan. In the absence of any other ideas, it might be worth a look to see what they propose.

Estate Tax Fix Introduced in Senate

In more tax news, Senators Jon Kyl (R-AZ) and Blanche Lincoln (D-AR) yesterday evening introduced an amendment to make permanent changes to the estate tax. As the entire tax world knows, the estate tax is taking a one-year hiatus in 2010 before returning in 2011 with a top rate of 55 percent and an exclusion of $1 million.

This dramatic shift, from a regime that applies a capital gains tax on inherited assets when they are sold to a very high 55 percent rate imposed at the death of the estate’s principal is possibly the largest marginal rate hike in history and is giving estates and estate planners alike a very real case of whiplash. Nobody predicted we would be in this situation a year ago, and the uncertainty is having a very real impact on how folks are behaving.

The Lincoln-Kyl proposal is designed to mitigate this harm and uncertainty by making permanent a middle ground on taxing estates. Key provisions in the bill include:

  • Reducing the top estate tax rate to 35 percent;
  • Increasing the exclusion from $1 million to $3.5 million; and
  • Allowing the estates of deceased taxpayers to choose between no estate tax and limited “carryover basis” or the provisions included in this plan for 2010.

Missing from the proposal are any revenue increases or spending cuts to offset the revenue loss of the lower rates and higher exclusion. The selective pay-go rules adopted by Congress earlier this year allowed Congress to extend 2009 estate tax rules without offsets, but any reduction in the estate tax beyond that would have to be offset or face a 60 vote Budget Act point of order. Filling this revenue hole, which has been estimated in the $50-$75 billion range over ten years, has been a significant challenge for the Lincoln-Kyl team, and it appears it still is unresolved.

While the Lincoln-Kyl proposal is targeted at the pending small business bill, it is unclear whether they will get a clean vote on the issue. Majority Leader Reid has filled the so-called amendment tree and is taking other steps necessary to limiting changes to the underlying bill. Regardless, the introduction of this legislation is the first substantive effort in the Senate to enact a permanent estate tax fix, which is progress. The question now is whether there’s enough time in the legislative calendar for this debate to play out. Stay tuned.