The Commerce Department's final report on 4Q GDP was revised from +2.2% to +2.5%.  For all of 2006, GDP rose by +3.2%.  The outlook for 2007 is for continued slow to moderate growth (2-3% in GDP) in the economy, with reasonably  low  inflation; a recession is not likely this year.  Recent economic reports have been mostly mixed to slightly negative, although unemployment fell to a new low of only 4.4% in March.

It is primarily the very strong jobs market that is keeping the US economy firmer than many analysts have predicted.  With unemployment low and falling, consumers have money to spend, and personal consumption expenditures rose 4.2% in the 4Q as compared to 2.2% in the 3Q.  Given the strong employment environment, and the fact that consumer spending accounts for apprx. two-thirds of GDP, the US economy should remain in positive territory all year, despite predictions to the contrary.

The housing market remains in a slump, and there are continued worries that the troubles in the "sub-prime" mortgage market could spill over into the prime mortgage market, thus causing even more trouble for the industry overall.  But as I discussed last month, these concerns appear to be overblown, and we have seen such fears move off the front pages.

The stock markets have been in a trading range following the plunge in late February/early March.  This correction from very overbought levels may continue for a few months, but a bear market is not the most likely scenario.  Periods of weakness should provide buying opportunities.

      As expected, the Democrats have passed legislation that will eliminate the Bush tax cuts when they expire.  This month, we will look at who pays most of the income taxes in the US, and debunk the liberal claims that tax cuts only help the "rich."  As we will see, the top 50% of income earners paid almost 97% of all income taxes paid, while the bottom 50% of income earners paid only 3.3% of all income taxes paid.  The top 5% of income earners pay over 57% of all income taxes paid, and the top 1% pay almost 37% of all taxes paid.  So much for the myth that the “rich” don’t pay their fair share!  Read on.

Introduction

This newsletter will reach you around the April 17 income tax filing deadline, so it’s only natural that our minds are on the subject of ... TAXES!  With the tax filing deadline upon us, I thought it would be interesting to discuss several issues related to income taxes, especially as they relate to the Bush tax cuts and what the Democrats are doing now that they are in charge.

Leading up to the November 2006 mid-term elections, there were a lot of scary stories going around regarding how the Democrats would repeal all of the Bush tax cuts if they were to be put into power.  Of course, this wasn't just hyperbole, as some of the Democratic candidates were saying they would do so if elected.

Once the Democrats actually gained control of Congress, a funny thing happened.  There was a lot less talk about dismantling the Bush tax cuts, and more talk about just tinkering around the edges.  How could this be, considering the Democrats and liberal press have been demonizing the Bush tax cuts since 2001?

Then, despite all of the post-election rhetoric, both the Senate and House did in fact pass budget resolutions that would allow all of the Bush tax cuts to expire after 2010.  Surprise, surprise - not really.  The Democrats did what they usually do.  If the Democrats are successful in allowing the Bush tax cuts to expire, it will represent the biggest tax increase in history. 

In the pages that follow, I'm going to attempt to sort out what is really going on in Congress with regard to taxes .  I'll also take some time to poke a few holes in the predictions made by Democrats when the tax cuts were enacted, and then provide some statistics about tax receipts and income levels that just might surprise you.

Democratic "Tax Reform"

As a general rule, when the words "Democrat" and "tax reform" are mentioned in the same paragraph, it usually means a discussion of how taxes are going to be increased.  That's because the Dems have historically been the party of tax and spend.  To be fair, recent years have shown us that the Bush Administration and a Republican-controlled Congress can spend with the best of them, but at least taxes weren't raised correspondingly.

During the months leading up to the November 2006 mid-term election, both sides were discussing the subject of taxes.  The Democrats, as usual, were continuing to demonize the Bush tax cuts and vowed to repeal them.  Democratic Representative Charles Rangel, now chairman of the powerful Ways and Means Committee, was quoted as saying that he "cannot think of one" of Bush's first-term tax cuts that deserved renewal.

The Republicans, on the other hand, were pointing to the beneficial effects the tax cuts have had on the economy, and how reversing them could lead to economic disaster.  They used the fear of tax increases as a campaign tactic, but to no avail.  The public's dislike for the Iraq war outweighed the concerns about tax increases.

Democratic Post-Election Retreat

As we all know, the Democrats came out victorious in the mid-term elections, taking over both the House and Senate.  However, a funny thing happened on the way to actually flexing their new-found majority muscle.  Articles started to surface quoting Democrats as saying they would not reverse the Bush tax cuts.

One such article quoted Democratic Senator Kent Conrad, chairman of the Senate Budget Committee, as saying, "Tax and spend, tax and spend, tax and spend.  We're not going there."  Other Democratic leaders said they saw no reason to discuss the issue of Bush's tax cuts, as they were not set to expire until 2010.  Instead, they said they would concentrate on closing the "tax gap," which can be defined as enforcing compliance with the tax code.

That's not to say that the Democrats didn't have their own tax initiatives.  A January 4, 2007 New York Times article indicated that the Dems were interested in preserving middle-class tax cuts like the child tax credit and a reduction in the "marriage penalty."  They also say they want to change or eliminate the Alternative Minimum Tax (AMT) - a goal they actually share with Republicans.  The problem with repealing this tax is that it would cost a projected $1 trillion over 10 years.

Another Democratic priority has become the budget deficit.  As a result, they have reinstated the pay-as-you-go "PAYGO" (pay as you go) budget rules like the ones that expired in 2002.  Under these rules, any increase in spending would have to be matched by comparable spending cuts (or tax increases) elsewhere.

Return To Tax-And-Spend?

Back to the Bush tax cuts.  As noted above, despite all of the post-election rhetoric about not touching the Bush tax cuts, both the Senate and House Democrats have recently pushed through budget resolutions that allow these tax cuts to expire after 2010.  I should make it clear that the House and Senate budgets do not specifically repeal the tax cuts, they just increase spending while allowing the tax cuts to lapse after 2010. 

Some Democrats want to retain some of the tax cuts aimed at the middle class, but the PAYGO rules require them to offset any revenue loss in the budget.  This will mean either spending cuts or higher taxes for someone.  Others, like Democratic Senate Budget Committee Chairman Kent Conrad indicate that tax money will be found by increasing enforcement and making sure taxpayers file their returns and pay their fair share.  However, the Heritage Foundation suggests that relying on more than just a few billion per year from increased compliance seems overly optimistic.

As noted above, the PAYGO rules require any future tax cuts or spending increases to be offset by tax increases or spending cuts elsewhere in the budget.  There can be exceptions, but any provision not meeting the PAYGO rules must be approved by 60 votes in the Senate.  This would effectively render any future attempt to extend the current Bush tax cuts dead on arrival, since 60% of the Senate would have to agree on just extending the existing cuts beyond 2010. 

Don't get me wrong, I'm not necessarily opposed to the PAYGO rules.  I believe the federal government (actually, any government body) should live within its means.  However, I also believe that tax cuts are favorable, as we have seen them work under both the Kennedy and Reagan administrations.  It just takes tax cuts longer to work through the economy, so any increased tax revenues may not fall within any particular budget window. 

Why Now?

While it was certainly never a stretch to believe that the Democrats would eventually get around to either repealing or allowing the tax cuts to expire on their own, it's interesting to me that they did so now.  After all, the tax cuts don't expire until 2010, well after the next presidential election.  So why hand the Republicans "tax increase" ammunition to use against them and their presidential candidate in 2008?

One reason may be that the Democrats allowed the "Blue Dog Coalition" to have a key role in writing the budget resolution.  This group, widely known as deficit hawks, is made up of moderate and conservative Democrats serving in the House and Senate.  Evidently, they see continued deficit spending as being a bigger political issue than allowing the tax code to revert back to what it was prior to the Bush tax cuts.  Thus, it may have been the influence of this group that caused the Democrats to act prior to the 2008 presidential election.

Another reason for the timing may be that the Democrats simply did not expect the Republicans to accuse them of increasing taxes.  I noted before how the budget resolutions did not specifically repeal the tax cuts, so perhaps the Democrats thought that just allowing them to lapse would draw no undue attention.  Though some of the Democratic response to-date appears to follow this line of thinking, I have to think they are more politically astute than this.

With the 2008 presidential race already under way, another possible idea might be that the Democrats wanted to get the idea of eliminating the tax cuts out soon after the mid-term elections, so that by the time the presidential race heats up in early 2008, it will be "old news."  They might feel that, by opening up a dialogue on increasing taxes now, it could help the eventual Democratic candidate, whoever that  may be.

Conservative columnist Robert Novak offered his take on this curious development in a recent editorial.  He said that passing the budget resolution represented "Democrats' belief they can politically survive this long-term commitment to bigger government.  Here is an audacious effort to raise the banner of fiscal responsibility while increasing spending and taxes."

Novak also takes note of a recent Democracy Corps poll showing voters think Democrats show more "fiscal responsibility" than Republicans by 44% to 36%.  That, along with their newfound commitment as deficit hawks, may have resulted in them believing their own rhetoric.  I, for one, don't believe it for a minute.  

The Democrats have hated the Bush tax cuts from day one, and it shouldn’t surprise anyone that they couldn’t resist themselves and took this action soon after their big victory in the 2006 mid-term elections.

Legacy Of The Bush Tax Cuts

For Democrats to allow the Bush tax cuts to expire ignores a very large reality - the tax cuts worked, as usual!  In my February 6 E-Letter, I noted how the tax cuts had helped the economy continue to grow, despite huge negative factors like rebuilding after hurricane Katrina, the war in Iraq, interest rate increases and record crude oil prices. 

Adding to that evidence, the Tax Foundation recently released a report showing additional benefits of the tax cuts, including a finding that government benefits received by low-income households far outweigh any taxes that they pay.  The Tax Foundation study, entitled "Who Pays America's Tax Burden, and Who Gets the Most Government Spending?" lays bare the claims that tax cuts favored only the very wealthy.  In fact, this study shows that the current tax code actually redistributes trillions of dollars from wealthy taxpayers to low-income homes.

According to a Tax Foundation press release, an analysis of federal, state and local taxes and government spending showed that the lowest-earning 20% of households received roughly $8.21 in government spending for each dollar of taxes paid in 2004.  Middle-income households receive approximately $1.30 per tax dollar, while the wealthiest households get back only 40 cents on the dollar.  Dear readers, this is called wealth redistribution. 

Using 2004 income tax data, the latest available, the study points out that about 44 million Americans pay no income taxes at all, while the top 5% paid 57.13% of the total.  IRS data for 2004 further reveal that the top 50% of taxpayers paid 96.7% of all income taxes, while the bottom 50% paid only 3.3%.  This is a larger share for the top 50% than when I last wrote about it back in 2003 when the 2000 income tax data showed the bottom 50% of taxpayers paid 4% of all income taxes.

It's even more telling when you delve deeper into the IRS data and compare 2004 with 1986, when the top 50% paid 93.54% of taxes and the bottom 50% paid 6.46%.  Thus, over an 18-year period, the share of income taxes paid by those in the bottom half of earned income has been cut almost in half.  But the media almost never refers to this fact.

The significance of the Tax Foundation study is obvious.  Liberals have constantly complained that tax cuts favor only the rich.  The study shows that low-income households receive far more in benefits than they pay in tax dollars - by a factor of 8 to 1.  And since many lower income households pay no income tax at all, their return is even greater.  This study shows that tax cuts, when properly designed, can help the economy and low-income households.

Now the Democrats want to reverse that trend by eliminating the bulk of the Bush tax cuts.  I noted above that the Dems want us to believe that simply allowing tax cuts to expire is not the same as raising taxes, which is just another Democrat talking point - and wrong as usual.  Estimates I have seen indicate that as many as 15 million lower-income Americans have been taken off of the tax rolls by the Bush tax cuts.  Allowing all of the cuts to expire would actually put many of them back on. If you weren't paying taxes, and now you are, is that not a tax increase?  You bet it is!

Remember, this is the same political party that told us if we followed Alan Greenspan's advice to use a different CPI adjustment factor for Social Security benefits, it would result in a benefit cut - because annual increases would be smaller than they would have been using the original CPI factor.  Using that logic, having benefits increase at a lower rate is a cut, but having your taxes increase from nothing to something isn't a tax increase.  Go figure! 

Republicans Go On The Attack

Predictably, Republicans have seized upon the Democrats' budget resolution and are playing the tax increase card.  Republican Representative Paul Ryan of Wisconsin was quick to take the Democrats to task.  He criticized their plan as one that would raise taxes "on every federal income taxpayer," and called the House budget resolution the largest tax increase in American history. 

The Heritage Foundation, a conservative think tank, estimates that the Senate budget resolution will result in a $2,641 tax increase per American household per year over the next decade.  The report also notes that the Senate budget contains 22 "reserve funds" that would give Congress almost unlimited authority to raise taxes, resulting in as much as a projected $4 trillion in tax increases over the next 10 years.

The attack continued as the Republicans' House campaign committee announced plans to go after 50 of the House Democrats who voted for this tax increase.  Many of these Representatives are freshmen who had unseated Republicans in the mid-term elections.  Thus, they are seen as vulnerable targets when they are up for re-election.

While the jury is still out as to whether the Republicans will be successful in their attempts to unseat Democrats who voted for this budget resolution, it remains a fact that the entire situation is one of the Republicans' own making.  Upon hearing the Republican attacks, some Democrats commented that, if the tax cuts were so important, why didn't the Republicans make them permanent when they controlled both houses of Congress and the White House?

That's a very good question, especially as we continue to see the positive effects of the tax cuts spread across the economy.  I have made no secret of the fact that I am very disappointed in the Bush administration and the Republican-controlled Congress for not moving forward with more items from the conservative agenda, including making the tax cuts permanent.

As the Democrats have recently shown, they are much more aggressive in pursuing their liberal agendas than the Republicans ever were in pursuing their agendas when they controlled Congress.

The 800 Pound Gorilla

While both Republican and Democrat rhetoric should be taken with a grain of salt, the fact remains that neither party has addressed the 800-pound gorilla in the room, and that's the upcoming retirement of 78 million Baby Boomers and the resulting budgetary strain from a massive increase in entitlement spending.  The Senate and House budget resolutions, as well as the Republican response, have all completely ignored the significance of January 1, 2008. 

That's the date when the oldest of the Baby Boomer generation reach early retirement age under Social Security.  Only three years later, this first wave will reach normal Social Security retirement age, as well as the age for Medicare eligibility.  After that, each year will see more and more Baby Boomers become eligible for benefits, and the "entitlement strain" will begin. 

And as I noted in my February 13 E-Letter, there's no Social Security "trust fund" to draw upon.  It's all smoke and mirrors.  The so-called Trust Funds now own government IOU's.  Thus, the federal government will have to start borrowing even more money to pay promised benefits as soon as benefits exceed incoming payroll tax revenues.  For Social Security, that date is estimated to be in 2018, just 11 years from now.  For Medicare, it's even sooner.  The total cost of Medicare, Medicaid and Social Security is projected to increase from 8.7% of GDP in 2006 to 19.0% of GDP by 2050, an increase of 10.3% of GDP. 

Without reform, the Heritage Foundation estimates that the money needed to pay for these programs will require a tax hike of $11,651 per household to fund the benefits, or the elimination of every other government program. Wow!

Democratic Senator Kent Conrad actually acknowledged this crisis in a recent "60 Minutes" interview on CBS.  He said, "They know in large measure here, Republicans and Democrats, that we are on a course that doesn't add up" but that Congress does not address the issue "[b]ecause it's always easier not to.  [I]t's always easier to defer, to kick the can down the road to avoid making choices.  You know, you get in trouble in politics when you make choices."

Well, Senator Conrad, you get in deeper trouble when you stick your head in the sand and refuse to deal with a problem.  On the same "60 Minutes" program, David Walker, comptroller general of the United States, made the following chilling comment:

"I would argue that the most serious threat to the United States is not someone hiding in a cave in Afghanistan or Pakistan, but our own fiscal irresponsibility."

These comments were made in regard to the upcoming "tsunami of spending" related to Baby Boomers entering the Social Security and Medicare programs.  This is pretty tough talk, but it echoes comments made by Alan Greenspan and Ben Bernanke.  The problem is that no one on Capitol Hill is listening, so Walker is taking his message directly to the people.

Walker speaks to civic groups, university forums, the news media and anyone else who will listen that the US has dug itself into a hole that it may find it difficult to climb out of unless it acts now.  He notes, however, that since there is no immediate crisis, the public and their representatives in Congress feel little need to take drastic action.

During his "60 Minutes" interview, Walker made the following additional comments and points, all of which should spur Congress into action, but they won't:

*   "…we suffer from a fiscal cancer.  It is growing within us.  And if we do not treat it, it could have catastrophic consequences for our country."

*   Walker has a power point presentation that shows the effect of unbridled spending over the next 30 years.  He states, "If nothing changes, the federal government's not gonna be able to do much more than pay interest on the mounting debt and some entitlement benefits.  It won't have money left for anything else - national defense, homeland security, education, you name it."

*   Walker tells the interviewer that the real problem "is health care costs.  Our health care problem is much more significant than Social Security.  By that I mean that the Medicare problem is five times greater than the Social Security problem."

*   "The prescription drug bill was probably the most fiscally irresponsible piece of legislation since the 1960s."

*   "Any politician who tells you that we can solve our problem without reforming Social Security, Medicare and Medicaid is not telling you the truth."

David Walker hopes that by taking his message to the American people, they will, in turn, empower their elected officials to stop "kicking the can" and make the tough choices necessary to fix the problems.  I wish him luck, but I'm afraid Congress isn't listening, and the recent Senate and House budget resolutions appear to be proof of that.

Conclusions

Let's cut to the chase.  Whether you are a conservative or a liberal, there are a few basic points that really aren't debatable; they're just facts.

1.  The top 50% of taxpayers paid almost 97% of all income taxes in the 2004 tax year (latest official data available from the IRS).

2.  Another fact is that many lower-income Americans not only pay no income taxes, but may actually qualify for tax credits that mean they get a refund over and above their tax savings.

3.  Considering that the bottom 50% paid only 3.3% of all income taxes, and of that group, many paid no taxes at all, it is virtually impossible for the Democrats to engineer any kind of tax reform that will not result in a significant tax increase across the board.

It's politics as usual in Washington, but it's your and my pocketbooks at stake.  Allowing all of the Bush tax cuts to expire will affect virtually every American taxpayer, many of whom had been relieved of paying taxes altogether.  Look for the Republicans to intensify their "tax and spend" attacks on Democrats as we near the 2008 elections.

I wouldn't, however, look for any monumental solutions for the entitlement crisis to come out of Washington anytime soon - from either party.  The Democrats may just be laying low, waiting to see if Hillary, Obama, or a yet-to-be-named candidate is elected to the presidency.  If that happens, the Dems may suddenly recognize the severity of the problems created by runaway entitlement programs, and increase taxes accordingly.  The Republicans had their chance to make the tax cuts permanent and address the entitlement programs and blew it.

Whatever happens in the next few years (tax cuts or tax increases), the retirement of the Baby Boomer is upon us, beginning next year and increasing significantly each year thereafter.  Entitlement spending will increase exponentially in the years ahead, yet virtually no one in Congress or the White House is willing to take any meaningful actions to address this looming crisis.

We should enjoy this great economy we have, save as much as we can and make the most of our investments.  We're all going to need it a few years down the road when the Baby Boomers start retiring en masses, and taxes will almost certainly be raised substantially, thereby hobbling the great US economy.  Barring a surprise, a democrat will be in the White House when this process begins to occur, so it would be wishful thinking to believe that taxes won’t be raised significantly in the coming years.  This is depressing, so I'm going to stop now.

WHO PAYS INCOME TAXES?

For Tax Year 2004

For Tax Year 2003

For Tax Year 2002