Republican gains in U.S. elections next month boost the odds of Congress letting Bush-era tax cuts die at year end, a worst case scenario for Wall Street, and the opposite of the party's stated goals.
Prospects had seemed assured for months that the current Democratic-controlled Congress would strike a deal to extend the rates before the end of 2010.
But now, with Republicans looking likely to take control of the House of Representatives and gain substantial influence in the Senate, tax policy watchers say neither side will be in a mood to bargain in the post-election "lame duck" session.
"I don't think Democrats are motivated to extend them and Republicans won't have the political base during a lame-duck to extend them all for as long as they like," said Scott Hodge, president of the right-leaning Tax Foundation.
Polls show Republicans making substantial gains in Congress in the Nov. 2 election — enough to block President Barack Obama's legislative agenda and perhaps even force his hand on some issues — on the back of voter angst about the economy and near 10 percent unemployment.
But a tax decision would likely come in the final days of the current session, and before the new Congress begins in January. Democrats will be in the majority in Congress in that period and political gridlock is possible.
A senior Democratic House aide said that a number of Democratic lawmakers have no interest in extending the Bush tax cuts for anyone.
"They are Bush's tax breaks and they never liked them in the first place," the aide said.
Wall Street economists have been cautiously watching for months, worried that political deadlock could lead all tax rates to expire, further choking the limp economic recovery.
"Political gridlock in Washington may not necessarily be a good thing," Bank of America economists wrote this week. "Inability for policymakers to compromise on the extension of the Bush-era tax cuts could shock the economy in 1Q 2011."
Tax rates for all individual income groups, including rates on dividends and capital gains, will rise at year-end if Congress fails to act.
President Barack Obama and most Democrats had tried to pass legislation extending low rates for families with income of $250,000 or less.
But a small but vocal minority in their own party backed a rival proposal from Republicans to extend all the tax cuts — including those for families with income above $250,000.
Republicans say extending lower rates for all taxpayers will boost the economy. But most Democrats say that wealthier Americans are unlikely to spend cash immediately and that the country can simply not afford the cost of the all the cuts.
Congressional Budget Office Director Douglas Elmendorff has advised that extending the tax cuts would be a short-term boost to the economy, but the increased government borrowing to pay for it, without any other changes in fiscal policy, would weigh heavily.
While the newly elected Congress does not convene until January, Republicans could gain four Senate seats right away due to vacancies that will be filled this year. But that might not be enough to get what many Republicans really want: long-term extension of all the Bush-era lower tax rates.
"Why would you settle for a half a loaf?" an industry lobbyist said of Republicans' potential strategy.
JP Morgan has estimated expiration of all the cuts could cut about 1 percent to 1.25 percent from GDP growth over the course of a year, as personal income falls.
If Congress allows the low tax rates to expire, it would likely just be temporary. Republicans and many Democrats would push to reestablish the tax cuts in some form in 2011.
Much depends on how fast Republicans can consolidate power.
"Obviously the sooner they fix it up the better," said Rudolph Penner, an economist at the left-leaning Urban Institute, who said it could be a "disaster" if they all expire.
Leading up to the election, Obama defended letting tax rates rise for wealthier Americans, about 3 percent of taxpayers, saying the country could not afford to keep missing out on $700 billion in revenue.
But will he change his mind with Republicans breathing down his neck?
"The big question is whether talk of 'Obama 2.0' means the president can climb down after his strident pre-election opposition to extending the tax cuts for upper income taxpayers," Capital Alpha analyst Jim Lucier said.
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