Noble Rot of the Tax Code Makes2007 a Grand Cru

April 12 (Bloomberg) — Tax years are like wine vintages.

A bad spot of weather — new taxes, high interest rates, or a recession — can annihilate the harvest. Good weather, by contrast, may yield sublimity and long afternoons.

Each year, each grape, each vineyard is different. And you don't know the quality of what you have until a few years after the harvest.

2007 has the makings of a glorious year for the U.S. taxpayer. Stocks have bounced back from their February stumble, unemployment is 4.4 percent, and tax rates are low. How many strong markets in the past have been accompanied by a capital-gains rate of 15 percent?

Both the obscure carried-interest provision, which lowers taxes for hedge-fund titans, and the low income tax for everyman have us feeling fine — something like the way you feel after a glass or two of a good Sauternes.

In fact, you can look at all of U.S. tax history as a succession of vintages. The years 1953, 1955 and 1959 may have been great years for red Bordeaux, but they produced only sour grapes when it came to taxes. President Dwight Eisenhower maintained the top marginal rate for the income tax at 91 percent.

By contrast, 1965 was smoother. The 1960s was the era of tax cuts by John F. Kennedy and Lyndon Johnson.

Not so happy were 1979, 1980 and 1981, especially the first two, though much of the misery stemmed from non-tax causes. There were some tax changes, though, in that period that opened the equivalent of a new wine continent, a veritable Australia. The biggest was the capital-gains rate cut, which caused California's venture-capital funds to invest like wild — and, incidentally, introduce the word sommelier to the California restaurant vocabulary.

Memorable Years

Another memorable year was 1989, not only for the high quality of the Bordeaux, but also the income tax. Even today, people speak reverently about the following year — the taste of 1990 Moselle, and the top marginal income-tax rate of 28 percent.

Of course, as with vintages, tax years are also about tradeoffs. Those who cared about the capital-gains tax rate remember the bitter side of those late 1980s harvests: To get the lower income tax, President Ronald Reagan traded the promise to raise the capital-gains rate to House Ways and Means Committee Chairman Dan Rostenkowski. But perhaps Rostenkowski didn't understand, Chicago being more of a beer town.

In taxes as in wine, good years are often followed by horrible ones. Enologists talk about "noble rot," a phenomenon relevant to that glass of Sauternes. A gray fungus attacks the grape and can render the wine especially sweet, transcendent to the palate. Uncontrolled, fungi and similar threats drive the vintner out of business.

Tax Advocate

We may be in for a series of bad years this time, as the Robert Parker of tax, William Beach of the Heritage Foundation, points out.

Social Security taxes are currently capped, and after about $100,000 or so in earnings, workers stop paying them. But Democrats from Charles Rangel of the House Ways and Means Committee on down are talking about removing that cap. And, as Beach notes, that would mean a marginal-tax increase of more than six percentage points. The rate is even higher when you count the matching taxes that employers may have to pay.

A nightmare vintage seems to be in store for 2011 as George W. Bush's income, dividend and capital-gains tax cuts phase out. The Heritage Foundation reckons about 4.7 million taxpayers, those who earn more $200,000, will pay higher taxes. They will confront an average tax increase of $14,000, or about the cost of a tour for two of the great estates of Burgundy.

California, New York

As Beach and colleagues Rea Hederman and Alison Fraser detail, the two U.S. states that would be most affected by the phase-outs happen to be wine states.

More than 15 percent of California workers, or 1.6 million people, will see a tax increase if Social Security's cap is lifted. Fifteen percent of filing households will experience the same because of the phase-out of the Bush rates. Eight percent of New York households would pay higher taxes because of the disappearance of the Bush advantage.

You can argue there is yet a third frosty factor ahead, one described by Nobel Prize winner Milton Friedman. Though hardly a bibulous type himself, Friedman developed a theory that would probably make sense to vintners, people who tend to invest for the long term.

Friedman called the theory the permanent income hypothesis. It says that people spend based not on what laws are passed from day to day but rather on their expectation of the policy outlook over a lifetime. If people expect taxes to go down, they will binge on spending now. If they expect a giant tax increase for the second half of their lives, they will be abstemious.

Ready to Drink

The mixture of U.S. demographics and lazy U.S. lawmakers practically guarantees that taxes will go up. Consumer spending and even investment may then wither. The country would be in the hangover of a tax recession.

There may still be action from lawmakers to save future vintages. George Radanovich, an anti-tax lawmaker from California, is also a scholar of the microclimate in Mariposa and a serious vintner. Look to him for a lecture on the similarities between entitlements and noble rot.

The Democratic lawmakers who now run the House and Senate can't be counted on to stop the spread of fiscal gray fungus. In wine terms, 2007 is a grand cru — conceivably, one of the last. Savor it.

(Amity Shlaes, a visiting senior fellow at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

© Copyright 2006 Bloomberg

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