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Tax Cut Uncertainty Could Distort Growth

As Washington continues to put off the decision to extend the Bush tax cuts or allow them to expire, the private sector has begun making assumptions. The Obama administration and most Democrats prefer to extend the tax cuts to all except those who earn more than $250,000 per year. Republicans want an across-the-board extension. The moderate approach would be a temporary extension for the rich. But those who might be affected by the Democrats' approach are already preparing as though their fate is sealed.

The Wall Street Journal reports that wealthier Americans, including some small business owners, fear that their taxes will rise next year. As a result, they are figuring out ways to declare income this year that would otherwise have been realized next year to take advantage of 2010's lower tax rates. Here's one example, provided by the WSJ:

Mike Henry, of Henry Wealth Management in Natchez, Miss., said he is trying to move up income that would normally be carried over into the next year. One idea is to sell timber growing on 500 acres of land he owns in Louisiana. He is considering that option even though timber prices have been dismal because of the prolonged downturn in housing construction.

Waiting for a better price on timber next year is "speculative at best," he said. "Even if the price does go up on timber, that increase will likely be eaten up anyway by the tax increases," Mr. Henry said. He said he is looking at other possibilities as well, including cutting back on his work hours and reducing his income.

"This is not tax evasion," he said. "This is year-end planning."

Some others are cashing out investments now, to take advantage of low tax rates. Many wealthy Americans are particularly savvy about managing their money, so this sort of planning is likely ramping up as they become nervous about their taxes. What effect might this have on the recovery? It could distort things.

Think of this like cash-for-clunkers or the home buyer credit: they both resulted in exaggerated economic activity followed by an unusually slow period. Similarly, if more small businesses and richer Americans are declaring income now instead of next year, then that will pull forward more income into 2010 and leave less for 2011. Since most of this income probably would have hit in early 2011, you can assume that late 2010 might seem better than it really is. Meanwhile, early 2011 might appear even worse.

Whether this is good or bad depends on your perception. On one hand, artificially boosting GDP growth in the second half of 2010 might calm double-dip fears. On the other hand, if early 2011 appears even slower than it is, then it could cause a full-on recession if sentiment is adversely affected. The timing here matters a lot.

At this point, however, it's pretty hard to judge how much this sort of activity would really affect GDP. The amount of income that might be pulled forward and the number of Americans who engage in this strategy aren't easy to predict. Of course, if the tax cuts are officially repealed for the wealthy, then the effect would be more significant. But if a full or temporary extension for this group ends up passing, then Washington should speed up things so to reduce the uncertainty that may be needlessly distorting the U.S. economy through this sort of activity.