As the debate concerning the future of the 2001 and 2003 tax cuts heats up, the Congressional Budget Office has released an updated Budget and Economic Outlook.  This report provides projections of federal revenues and spending for the next 10 years.

Under present law, on January 1, 2011 the top marginal income tax rate, paid by individuals and small businesses, increases from 35% to 39.6%, the long-term capital gains tax rate increases from 15% to 20%, and the dividends tax rate returns to the individual income tax rates (up to 39.6%).  The estate tax also reverts to higher rates and lower exemption amounts.

For the housing sector, these tax policy changes matter for businesses and home buyers.  For home builders and other small businesses organized as pass-thru entities (LLCs, S Corporations, partnerships, etc.), increases in the top individual tax rates represent tax increases on business income. But a large budget deficit for the federal government can have the effect of increasing interest rates, thereby raising the cost of borrowing for business lending and home mortgages.

At the present, the debate between tax policy makers primarily concerns the fate of the top individual income tax rates and whether the capital gains and dividends rates will be 15% or 20%.

However, the impact of extending the 2001 and 2003 tax cuts is fairly small relative to the mismatch between projected federal spending and revenues.

Under either scenario, federal revenues return to their historical average of approximately 18% of gross domestic product (GDP). Letting the tax cuts expire results in a return to the historical average in 2012; not letting them expire (and indexing the AMT for inflation) sees a return to the norm in 2014. This suggests that the budget deficit in the near future will be due to elevated government spending. 

Regardless of the cause, the large federal budget deficit means policymakers will be paying attention to the President’s National Commission on Fiscal Responsibility and Reform when it makes its recommendations concerning entitlements, government spending, and taxes on December 1, 2010.