Happy New Year everyone!
As everyone knows, the President signed into law H.R. 8, the so-called mini deal addressing the fiscal cliff yesterday.
The agreement was the result of negotiations between Vice President Biden and Senate Republican Leader McConnell and effectively reduces tax revenues over the next ten years by just short of $4 trillion dollars.
It passed the Senate easily early New Year’s morning by an 89-8 vote and then, after a little drama with the House Republican conference, passed that body on a much closer 257-167 vote that evening.
For S corporations, the package is a mixed blessing. Under the agreement, top rates are going up for shareholders making more than $450,000 (joint filers) starting January 1st, but those rates were going up anyway had Congress and the Administration failed to come together and now they are offset with permanent AMT relief, permanent estate tax rules, 179 expensing, and lower rates on dividends.
Bottom Line: Compared to where tax policy would have been without an agreement, the S corporation world is in a much better place starting out 2013 with H.R. 8 signed into law.
Specific to the work we’ve been doing, the bill includes an extension of the five-year built-in gains (BIG) holding period for tax years beginning in 2012 and 2013! The specific language is in Section 326 (page 54) of the bill. The bill also extends the basis adjustment to stock of S corporations making charitable contributions of property.
Many, many thanks to our congressional allies, including Sen. Ben Cardin (D-MD), Sen. Olympia Snowe (R-ME), Rep. Dave Reichert (R-WA), and Rep. Ron Kind (D-WI) for helping to ensure the BIG provision was included in the extender package.
Other highlights in H.R. 8 include:
- Permanent extension of the marginal rates for individuals making under $400,000 and couples under $450,000;
- Permanent extension of the PEP and Pease personal exemption and itemized deduction phase-outs for individuals making under $250,000 and couples under $300,000;
- Permanent extension of current capital gains and dividends rates for individuals making under $400,000 and couples under $450,000. (For those over those thresholds, the rate for both cap gains and dividends is 20 percent (plus the new 3.8 percent tax from the healthcare bill));
- Permanent estate tax relief providing for a $5 million exemption ($10 million for couples) and a new top tax rate of 40 percent;
- Permanent AMT relief;
- Tax extenders, including built-in gains relief (generally for 2012 and2013);
- One-year extension of bonus depreciation;
- Five-year extension stimulus bill tax credits;
- One-year extension of unemployment benefits;
- One-year extension of the Medicare reimbursement rate for doctors (“Doc Fix”/SGR) offset with other healthcare related provisions;
- Two-month delay in the sequester offset in part with the new tax revenue generated from the package and inpart with spending cuts; and
- Extension of farm policies through September.
Outlook for 2013
With the fiscal cliff out of the way, attention will now shift to the upcoming debt limit fight and the possible contents of a deficit reduction package to accompany legislation to raise the debt limit.
Treasury announced in late December that federal debt had reached the current limit and that, by using extraordinary measures, it could keep overall debt under the caps only until sometime in late February or early March. Which means that Congress, having just finished the contentious fiscal cliff fight, will have to turn almost immediately to a sure-to-be-just-as-contentious debt limit fight.
Other reasons tax policy will remain front and center in coming months:
- Ways and Means Chairman Dave Camp has promised to consider broad-based tax reform early 2013 – “We can and will do comprehensive tax reform this year, in 2013”;
- The two-month delay in across-the-board spending cuts (sequester) expires on March 1st; and
- The Continuing Resolution funding the federal government sunsets March 27th.
All these events suggest that, whether they want to or not, Congress will be knee deep in tax policy from now until all of this gets resolved. Having just seen S corporation tax rates rise from 35 percent to nearly 45 percent, the S corporation community needs to be as active as ever in making the case why further tax hikes on pass-through employers is bad for jobs and economic growth.
That’s the message we’ll be taking to the Hill… starting now.
Text of the letter we sent to Speaker Boehner earlier today:
The S Corporation Association would like to thank you for all your work over the past two years to protect closely-held businesses and ensure that as Congress considers changes to the tax code, privately-owned businesses are not harmed or singled out.
With that in mind, the S Corporation Association supports H.J. Res. 66, the “Permanent Tax Relief for Families and Small Businesses Act of 2012.” While H.J. Res. 66 would allow tax rates to rise for S corporation owners with incomes above $1 million — something we oppose — it is the best of all the options before Congress and it sets the stage for comprehensive, pro-growth tax reform in 2013.
By making permanent relief from higher rates (up to the $1 million threshold), the estate tax, the Alternative Minimum Tax, and the limitations on deductions, H.J. Res 66 helps privately-held businesses immediately by giving them the certainty they crave. The recent sharp decline in the National Federation of Independent Businesses’ survey of small business owners should serve as a grave warning to all policymakers — Congress needs to act now to provide private employers with certainty or risk seeing the small business sector, and the economy as a whole, pull back and contract. H.J. Res 66 provides some of that certainty.
Moreover, H.J. Res 66 improves the odds that Congress will be able to enact meaningful, comprehensive tax reform in 2013. By making the permanent a large part of the tax code, the legislation ensures that the debate over tax reform will be focused on moving the tax code forward through rate reductions and base broadening, rather than endlessly debating the continuation of existing provisions that are due to sunset sometime in the future.
The S Corporation Association has been a leading voice in the business community in opposing raising marginal tax rates on employers while supporting comprehensive tax reform that lowers rates on all forms of business income. The legislation before the House of Representatives is not perfect, but it is our view that it is the best of all options being considered, and it does the best job of setting the stage for the enactment of positive tax policies moving forward.
Thank you for your efforts and for continuing to defend private enterprise.
The vote on Plan B is scheduled for tonight.
Can Main Street Businesses Elect C Corp Status? Should They?
The idea that corporate-only tax reform isn’t so bad because Main Street businesses can elect C corporation status and access the lower rates has been floating around DC for months, but we’ve never had the idea sourced until last week’s Politico Pro report:
“A lower corporate tax rate that will keep American businesses more competitive in an increasingly global economy is critically important, but it cannot come on the backs of the small business community, which is why corporate reform must be linked with individual reform,” Caldeira said Tuesday afternoon in his statement to POLITICO.
Groups like the RATE Coalition — which represents larger corporations such as AT&T, Boeing, Ford, Lockheed Martin — dispute this logic.
Elaine Kamarck, the coalition’s co-chair, said last week that the two overhauls should be separate and that small businesses could just switch to the corporate code.
“There’s also an argument that some of those [small] businesses and pass-throughs might become corporate,” she said. “There is nothing that keeps them from switching. Because of the high corporate tax rate they don’t file [under the corporate code]. So I think that is less of a problem than some people would guess it to be.”
A later version of the story included this new quote:
A spokesman for the group, which represents big names such as AT&T, Boeing, Ford and Lockheed Martin, said Tuesday evening, however, that Kamarck’s views were her own and the coalition supports comprehensive tax reform.
We’re glad the RATE Coalition clarified that they support comprehensive reform, but what about the other issue raised here. If the corporate rate is reduced, should pass-through businesses just switch to C status to access the lower rates? The answer is no. Here are the main points:
It’s the opposite of tax reform. Taken as a whole, the corporate-only approach is effectively “anti-tax reform” in that it will return us to the pre-1986 era, when corporate tax rates were significantly lower than the top individual rate and tax shelters and gaming dominated taxpayer behavior.
- It’s a tax hike either way. S corporations that retain their S status would pay a top rate of 45 percent on their earnings. Meanwhile, those that switch to C corporation status would pay the new lower corporate tax of 25 percent, but also be subject to the second layer dividend tax. The dividend rate is scheduled to rise from 15 to 45 percent next year, so the total effective tax on the new C corporation would be as much as 59 percent! With the lower dividend rate envisioned in the Senate-passed bill, the combined rate still would exceed 40 percent.
- The double tax applies to the sale of a closely-held C corporation too. When an S corporation owner sells their business, they pay the capital gains rate on any gain. The same treatment applies to the shareholder of a publicly traded corporation — they pay a single tax at the capital gains rate. But gains from the sale of a closely-held C corporation are taxed twice, first at the corporate rate and again at the capital gains rate. Even with the lower corporate rate of 25 percent, that still means a total effective tax of over 40 percent.
Let’s take these points one at a time:
- Corporate-Only is Anti-Tax Reform
S-Corp Advisor Tom Nichols hit this point in his testimony before Ways and Means earlier this year:
When I first started practicing law in 1979, the top individual income tax rate was 70 percent, whereas the top income tax rate for corporations taxed at the entity level (“C corporations”) was only 46 percent. This rate differential obviously provided a tremendous incentive for successful business owners to have as much of their income as possible taxed, at least initially, at the C corporation tax rates, rather than at the individual tax rates, which were more than 50 percent higher.
This tax dynamic set up a cat and mouse game between Congress, the Department of the Treasury and the Internal Revenue Service (the “Service”) on the one hand and taxpayers and their advisors on the other, whereby C corporation shareholders sought to pull money out of their corporations in transactions that would subject them to the more favorable capital gains rates that were prevalent during this period or to accumulate wealth inside the corporations. Congress reacted by enacting numerous provisions that were intended to force C corporation shareholders to pay the full double tax, efforts that were only partially successful.
Efforts to lower the corporate rates while raising individual and pass-through rates should be deemed “anti-tax reform”. They will return us to the world Tom describes above, effectively reversing the broad changes made by Congress in 1986 and creating a tremendous incentive for taxpayers to organize their income to take advantage of the lower corporate rates and then shelter that same income from the higher rates.
- Either Way, It’s a Tax Hike
Consider the scenario embraced by the Administration, where the top marginal rate for individuals rises to 45 percent, the corporate rate drops to 25 percent, but the tax on dividends increases to 45 percent:
- Under the current rules, if our S corporation made $100 dollars this quarter, its shareholders would pay $35 in federal taxes (same as a C corporation) regardless of whether the income is distributed or retained by the business.
- Next year, under the Obama scenario where the top rate rises to 39.6 percent, plus the new 3.8 percent investment tax, plus the reinstatement of the Pease limitation on deductions, our S corporation’s shareholders could pay as much as $45.
- Finally, if we were able to convert to C, we would pay $25 initially but then face a choice — either retain the income at the firm and avoid the second layer of tax, or pay out a dividend and pay another $34 in taxes (the 45 percent dividend tax times $75), for a total tax hit of $59. If the dividend rate is 23.8 percent next year (as proposed by the Senate), then the combined tax would be 43 percent.
You’ll notice that the converted C corporation has a very strong incentive to keep its post-tax income within the firm and not pay that second layer of tax. If our business has a single, active shareholder, it might be an option. He can just retain the earnings and adjust his salary and bonus to meet his income needs and shelter the rest (see argument 1).
But what if we have multiple shareholders, many of whom don’t work at the business and rely on the business’ income to finance their lives? Avoiding the second layer of tax isn’t really an option there, so converting to C would be less attractive, particularly with the possibility of a 45 percent tax rate on dividends.
Meanwhile, for S corporations that retain their earnings, lowering only the headline C corporation rate means that their publicly held competitors would pay a lower tax on earnings retained in the business, in addition to having access to the public markets and all of the other advantages of being a much larger business. Does this make sense when most job creation comes from pass-through businesses?
- Double Tax Applies to Business Sales
The “they can just convert” argument also ignores the penalty closely-held C corporations face when they are sold. The 1986 Tax Reform Act applied the double layer of tax onto sales of closely-held C corporations, which means a C corporation sold this year is subject to a combined federal tax rate of nearly 45 percent versus just 15 percent for the sale of an S corporation. Under the Obama approach of lower corporate rates but higher capital gains rates, the effective tax would be 43 percent.
This double tax makes switching to C corporation status a non-starter for any entrepreneur who might sell their business someday. Many business sales are tied to the retirement of the owner, where the proceeds are used to fund their retirement, so rates that high are a threat to their retirement security.
It’s different for publicly held C corporations. Individual stockholders can sell at any time, often at higher multiples, and business to business acquisitions can be done with stock, often on a tax-free basis, once again giving public C corporations a tax advantage over private ones.
So arguing that pass-through businesses can just “convert” simply is not credible. Some businesses might be in a position to switch to C status, but there are higher taxes waiting on the other side. Given that pass-through businesses employ more than half the private sector workforce, how does any of this make sense? More broadly, how does forcing more companies into the inefficient and investment-stifling double tax model make America’s companies more competitive? Sounds like a plan to do the exact opposite.
S Corporation Association Board Member Dan McGregor participated in a small business roundtable with House Republican leadership yesterday as part of our ongoing effort to educate policymakers on the important role pass-through businesses, and particularly S corporations, play in job creation and investment.
Dan is Chairman of McGregor Metal Working, a group of metal-stamping companies located in the Springfield, Ohio area. It’s been a family-owned business since 1965 and began as an eight-person tool and die shop. Today, they employ 365 workers and have clients in the auto, agriculture, and lawn and garden industries.
A key part of Dan’s message yesterday was that higher tax rates means lower retained earnings, which means less capital to invest and create jobs.
Ironically, Dan’s trip to the Capitol occurred on the same day that FedEx founder Fred Smith argued that it’s a “myth” that McGregor Metalworking and similar pass-through businesses are an important source of jobs:
“The reality is the vast majority of jobs in the United States are produced by capital investment in equipment and software that’s not done by small business. It’s done by big business and the so-called ‘gazelles,’ the emerging companies like the new fracking oil and gas operations. It is capital investment and equipment and software that’s the solution to our economic problems, not the marginal tax rates of individuals.”
The ignorance of this statement is remarkable, especially given the source. As readers of our E&Y study know, fifty-four percent of all private sector jobs come from pass-through businesses — one quarter of all private sector jobs are at an S corporations.
Moreover, it’s hard to believe there’s a more capital-intensive industry than metal stamping, and for a private business like McGregor, there are few viable options for raising capital other than retained earnings.
If McGregor wants to grow, it needs to earn a profit and reinvest those profits in the business. Raising taxes on McGregor — as proposed by the President — would increase McGregor’s effective tax rate sharply, which means less retained earnings and less ability to invest and grow. As the President is fond of saying, “It’s just math.”
So the President can push for higher taxes on a million or so private businesses, and billionaires like Fred Smith and Warren Buffett can support him, but don’t pretend it’s not going to affect real people and real jobs. It will. It already has.
CBO Weighs In
S corporations sure are popular these days. Unfortunately, they’re popular in the same way that big Tom Turkey is popular around Thanksgiving. Yesterday, the Congressional Budget Office added to the feeding frenzy, releasing a report entitled “Taxing Businesses Through the Individual Income Tax.”
There’s actually good stuff in there, like how S corporations help to reduce the cost of business investment and how they reduce the tax code’s bias toward too much debt , but it’s all for naught. Those big government types tying on their napkins and sharpening their knives will only see this:
The Congressional Budget Office (CBO) estimates that if the C-corporation tax rules had applied to S corporations and LLCs in 2007 and if there had been no behavioral responses to that difference in tax treatment, federal revenues in that year would have been about $76 billion higher.
You can hear them drooling already — $76 billion a year will pay for lots of new government. But if there is no change in behavior? And if there’s no interaction with the AMT? That’s akin to saying, if there was no structural federal deficit, we wouldn’t need all these tax hikes.
Let’s start with the behavior. For a sense of just how much taxpayer behavior would change if all pass-through businesses were suddenly subject to the double corporate tax, go back to pre-1986 tax reform and see how they behaved. Tax sheltering ruled the day then, and we expect it would return to prominence again in a double tax world. Here’s S-Corp Advisor Tom Nichols’ testimony before the Ways and Means Committee earlier this year:
Prior to the TRA ’86, successful business owners were regularly engaged in the tax planning process in order to minimize the substantial burdens under the double taxation regime. Since that time, and with the migration of closely-held business activity to pass-through taxation treatment, business owners are no longer engaged in an ongoing struggle to navigate the heavy impositions of the double tax system. They are less focused on tax planning than they were before the TRA ’86, and more focused on running their business.
The AMT exception is particularly important, too. Just about every other business owner we know pays the AMT, so pretending it doesn’t play a significant role is less than credible. Moreover, why didn’t the CBO calculate the impact of the AMT? E&Y did in our study on the impact of higher rates on jobs and investment. They found that of the 2.1 million business owners with incomes high enough to pay the top two rates, 1.2 million of them already pay the AMT.
If E&Y can make that calculation, why can’t the CBO?
So the take-away for the “tax the rich” crowd will be that they’re losing $76 billion a year by allowing pass-through businesses. But that number’s not real. Congress will never collect it.
On the other hand, the higher cost of capital is real. Here’s how E&Y put it:
The income of C corporations is instead subject to two levels of tax (the “double tax”), first when income is earned at the corporate level, and again when the income is paid out to shareholders in the form of dividends or retained and later realized by shareholders as capital gains.
The double tax affects a number of important economic decisions. In particular, the double tax:
- Increases the cost of capital, which discourages investment and reduces capital formation and economic growth.
- Increases the cost of equity finance, which encourages greater leverage among C corporations.
The flow-through form provides an important benefit to the economy by reducing the economically harmful effects of the double tax and therefore allowing for a greater opportunity for job creation and capital investment. Moreover, the flow-through form provides businesses with flexibility that may better match their ownership structure requirements and capital needs.
Bottom Line: All businesses should be taxed as S corporations, not the other way around. It would mean more investment, more jobs and higher wages.
Isn’t that the whole point?
Retained Earnings v. Distributions
Speaking of myths, one of the arguments we’ve heard from reporters and others in recent days is that because wages are deductible, hiring will not be impacted by higher tax rates.
This argument reflects a basic misunderstanding of how pass-through businesses, including S corporations, are taxed. S corporation shareholders must pay taxes on any income earned by the business, whether the income is distributed to the shareholders or not. This is an important feature of S corporation taxation that many observers fail to grasp completely, and it’s critical to understanding the concern that higher marginal rates will result in less job creation.
Here’s an example:
Start with a two-shareholder S corporation where each owner has a 50 percent interest. If the S corporation makes $200 dollars in a quarter, each shareholder would be required to pay taxes on the $100 in earnings attributed to them, regardless of whether the shareholders actually received any distribution!
Most S corporations make sure to distribute at least enough earnings each quarter to cover the shareholder’s taxes. In this case, both shareholders are in the 35 percent bracket, so the business would distribute $35 to each to cover their taxes, and retain the remaining $130 as working capital for the business.
Under the President’s approach, next year the marginal rates on our shareholders will rise to 39.6 percent, so the business would need to distribute $40 to both shareholders. As a result, the business’ working capital is reduced to $120.
But these higher statutory rates are only one of three rate hikes facing pass-through businesses next year. There’s also the marginal impact of reinstating the Pease cap on itemized deductions. That has the effect of raising the marginal rate by 1.2 percent.
And then there’s the imposition of the new 3.8 percent investment surtax enacted as part of health care reform. That only applies to shareholders who don’t work at the business, but it’s another 3.8 percent on top of the other two tax hikes.
The net result will be to raise the top marginal rate on S corporation shareholders from 35 percent to around 45 percent (not including state and local taxes). With those rates, our business’ working capital would be reduced from $130 to $110, a reduction of 15 percent!
Interestingly, that’s just about the same percentage that E&Y estimated the cost of capital would rise for pass-through businesses if the President gets his way on tax rates. Think of it as a reverse sale — instead of 15 percent off that new equipment, next year it’ll be 15 percent more.
And that’s why higher rates cost jobs. Higher rates mean lower after-tax earnings and less money to invest in jobs and equipment. Period.
Health Reform Investment Taxes Will Hit S Corps
The IRS waited until a Friday afternoon after the elections to release 159 pages of proposed regulations on the new 3.8 percent investment tax. While the rule is not final, the IRS is telling taxpayers to rely on this temporary guidance until they can get around to making them final. Here’s what the IRS says:
Taxpayers may rely on the proposed regulations for purposes of compliance with section 1411 until the effective date of the final regulations.
Just to remind folks distracted by the fight over extending the Bush tax cuts, two of the new taxes enacted to pay for health care reform will take effect beginning January 1:
- A 3.8 percent tax on all net investment income for taxpayers earning more than $250,000 ($200,000 if you’re single); and
- An additional .9 percent Medicare tax on salaries and wages for taxpayers making more than $250,000 ($200,000 if you’re single).
The rule released Friday addresses the investment tax. Forbes has a nice write up together with some examples of how taxpayers might be impacted. For S corporations, income from the business is not subject to the new 3.8 percent investment tax if the taxpayer is active in the business and the income is active rather than passive in nature. Here’s the Forbes example:
Example: Walter White owns an interest in two S corporations. Both corporations are engaged in the active conduct of a trade or business, and neither corporation is a trader in financial instruments. Walter spends 520 hours on S Corporation 1, but only 40 hours on S corporation 2. Under the Section 469 regulations, absent an election to group the two activities, Walter would materially participate in S Corporation 1, but not S Corporation 2.
Assuming the interests in the two corporations represent an appropriate economic unit, Walter may group them together for purposes of testing material participation. Because Walter spends 560 hours on the combined activity, he materially participates in both S corporations and neither activity is passive to Walter. As a result, income earned in the ordinary course of the trade or business of both S Corporation 1 and S Corporation 2 will not be considered net investment income.
We’ve commented on these new taxes previously, but suffice it to say that this guidance should make clear to policymakers that we’re not returning to the 1990s tax rates next month — we’re going well beyond.
While everyone in Washington waits for Tuesday’s election results, this story in The Hill caught our eye: “Fiscal cliff already weighing on economy.” According to the story:
While the expiring tax cuts and automatic spending cuts that make up the cliff do not take effect until the beginning of 2013, Pawlenty said he is hearing from financial firms that businesses are already halting business activity because they are not sure what will happen.
For example, 61 percent of JPMorgan’s U.S. clients are altering their hiring plans because of the cliff, and 42 percent of fund managers for Bank of America identify it as their greatest investment risk.
That’s consistent with what our S-CORP members are telling us. Faced with higher tax rates, uncertain health insurance prospects, and lagging employment growth, the S corporations we hear from are choosing to forego hiring and investment decisions until they feel more confident about the future of public policy and the economy.
This suggests the so-called fiscal cliff is more of a downward slope, and we’re already on it. Employers are holding back, which is suppressing investment and hiring decisions right now, and that’s reflected in the less-than-stellar jobs and GDP numbers we’ve been seeing for the past six months.
That also means that any signal that Congress is prepared to address the cliff and block these tax hikes would help the economy immediately– not just after January 1st.
So, what’s at stake for S corporations? Here’s a short list:
Tax Rates: The best case is that current rates are extended for 2013. The worst case is total gridlock in Congress and rates rise to their pre-2001 levels and beyond. (Beyond because of the tax hikes included in health care reform). Here’s a table summarizing the options:
Wage & Salary
S Corp Income
Keep in mind, the best case scenario includes both extending current rates and repealing the new 3.8 percent investment tax imposed under Obamacare. Not impossible if Romney wins and Republicans take the Senate, but not easy either.
AMT: One of the findings in our E&Y study released this summer was the significant number of pass-through owners who pay the AMT. According to E&Y, of the 2.1 million business owners who earn more the $200,000 annually, 900,000 pay the top two tax rates, while 1.2 million pay the AMT. This suggests that the expiration of the so-called AMT patch last year may have more impact on pass-through business owners than the expiration of the lower rates. Treasury estimates that 30 million additional taxpayers will be pulled into the AMT April 15th under the current rules (if the AMT patch remains expired). The findings of E&Y suggest many of those taxpayers are business owners. Business owners most at risk are those with dependent children and those living in high-tax states like New York and California.
Extenders: Congress has gotten into a [bad] habit of ignoring the expiration of all those tax provisions falling under the title of “extenders” — the R&E tax credit, the state and local tax deduction, the shorter built-in gains holding period, etc. The Senate Finance Committee has passed a package of extensions, but the House has yet to act. If and how these important issues are addressed during the lame duck are still to be determined, and unfortunately seem to have taken a backseat to dealing with the “must-do” broader 2001/2003 extenders that are set to expire at year’s end.
Those are the tax provisions directly impacting the S corporation community. Couple them with the spending cuts scheduled to begin January 1st, and the total makes up the $700-plus billion fiscal cliff.
What might happen?
Our friends at International Strategy & Investment in the past suggested that the choice before Congress is not “all or nothing” and we agree. Rather than be constrained by the idea that we will either fall off the cliff or step back entirely, our view is that Congress will take a half-step back, avoiding the most damaging pieces of the cliff while allowing others to take effect. Here’s a list with those cliff provisions most likely to be avoided starting at the top:
- Middle-Class Tax Relief
- Doc Fix
- Tax Extenders
- Extended UI Benefits
- Upper Income Tax Relief
- Health Care Reform Tax Hikes
- Discretionary Spending
We’ve highlighted the tax rates on upper income taxpayers, including S corporations, since their extension depends almost entirely on who wins the White House. The odds they get extended is close to zero under President Obama, and perhaps 50-50 under a new Romney Administration. Romney has made clear he will push for them, as has the House — it’s the Democrats in the Senate that are the wild card. As for the rest of the provisions, there may be some movement based on the elections, but not much.
In addition to the policies, there’s a question of timing. The general notion is that any deal on the fiscal cliff must occur before the end of 2012, but several of the provisions listed above could just as easily be dealt with in the first few weeks of 2013 with little additional harm to the economy, particularly if Congress and the incoming Administration effectively signaled what they had in mind. Moreover, with only a few weeks between the elections and the holidays, there may simply be insufficient time for the differing parties to come together.
But that doesn’t mean it’s okay to wait. Action immediately after the election to address the entire fiscal cliff — including the top tax rates — would help improve people’s lives now through increased hiring and increased business investment. Congress should act, and act quickly.
But will they? Not if their recent behavior, particularly in the Senate, is any indication. So our best pre-election guess is that Congress will act eventually, but only at the last minute, and that most of the fiscal cliff will be averted either prior to the end of the year or shortly thereafter.
The rate debate continues. Last week, the Senate failed to extend all the current tax rates and policies by a vote of 45-54. Two Republicans voted against the measure because of a refundable credit issue and one Republican missed the vote due to illness, but even if you adjust for those votes, the Senate still came up short of a majority for not raising taxes on employers during a period of severely high unemployment.
Very disappointing and something pass-through businesses and the markets should pay sharp attention to.
We expect better results today and tomorrow when the House votes on two related bills. One, H.R. 8, would extend through 2013 all the current Bush tax cuts. The other, H.R. 6169, would create an expedited process for Congress to consider tax reform next year.
To help with the vote, the S Corporation Association and our allies drafted and helped circulate the following business community letter in support of the legislation. As the letter states:
Business owners in this country crave clarity. They do not know what the tax laws will be moving forward and this uncertainty is having a material and negative impact on investment and job creation.
Absent action, the Congressional Budget Office has made clear the combination of higher taxes and lower spending will send the economy into a tailspin starting early next year. Our members report that the prospect of the country going over the fiscal cliff is discouraging them from making investment and hiring decisions right now, slowing our already sluggish economy.
To address this uncertainty, Congress needs to act quickly on tax legislation that would accomplish two critical goals. First, the legislation must shrink the fiscal cliff and provide employers with a clear sense of the tax rules for 2013 by extending all of the expiring tax provisions for one year.
Second, because it is long past time for comprehensive reform to create a pro-business, pro-competitiveness and pro-jobs tax code, the legislation should outline exactly how and when Congress will consider a comprehensive rewrite of the individual, corporate and international tax codes. This legislation should instruct Congress to broaden the tax base while lowering overall rates, and include rules for expedited consideration of the legislation to prevent delay or filibuster to provide the long-term certainty our economy needs to flourish.
This letter has been signed by more than 100 business trade groups, which should send a strong signal to policymakers in both chambers that the employer community needs to see action. The House plan is the most responsive to the needs of our members, and we hope Congress will adopt it.
Finance Hearing on Pass-Through Businesses
The Finance Committee held a hearing on tax reform and business entities today. Entitled “Reform: Examining the Taxation of Business Entities,” the goal of the hearing was to:
…explore the different taxation of business entities structured as corporations versus pass-throughs, and to consider proposals to alter those rules. Baucus and the witnesses will explore the history of the two-tiered corporate tax system, compare the U.S. taxation of pass-throughs to the systems of other countries and consider whether the current system distorts business decisions in ways that hurt job creation and economic growth.
This topic is obviously of great importance to S corporations and we submitted some excellent testimony from S-Corp Advisor Tom Nichols that outlines our views on tax reform and entity choice. His testimony is consistent with last fall’s trade association letter signed by 47 major business organizations that outlines three key priorities pass-through businesses would like to see under tax reform:
- Reform needs to be comprehensive and include the individual and corporate codes;
- The top rates for individuals, pass-through businesses, and corporations should stay the same; and
- Congress should continue to reduce the double tax on corporate income.
The final priority here is particularly important. If the goal of tax reform is to improve incentives for domestic job creation and investment, it needs to address the burden of the double tax on American corporations. Congress has proactively worked to reduce this burden for the past three decades, and that progress should continue in any future tax reform. As our Ernst & Young study authors observed in the report they did for us last year:
In addition, the flow-through form helps mitigate the economically harmful effects of the double tax on corporate profits, in which the higher cost of capital from double taxation discourages investment and thus economic growth and job creation. Moreover, double taxation of the return to saving and investment embodied in the income tax system leads to a bias in firms‟ financing decisions between the use of debt and equity and distorts the allocation of capital within the economy. As tax reform progresses, it is important to understand and consider all of these issues with an eye towards bringing about the tax reform that is most conducive to increased growth and job creation throughout the entire economy.
We’re grateful that a number of today’s witnesses sounded the same theme, but remain concerned that Finance Chairman Max Baucus continues to suggest that large pass-through businesses should pay taxes as C corporations. From his opening statement:
While a valuable tool for small businesses, we should examine if the use of pass-throughs have disrupted the level playing field for larger non-public companies and their public competitors.
Ideally, our tax code should cause as few distortions in business as possible. Businesses should plan and organize based on growth and job creation – not the tax code.
One of my main goals of tax reform is to make the system more competitive, but also keep it fair.
These comments build on remarks he made last year, stating that, “We’re going to maybe, have to look at pass-throughs, and say they have to be treated as corporations if they earn above a certain income.”
As we said, most of the witnesses and Members supported the notion that tax reform done right would reduce the double tax on corporate income, not increase. As the Chairman’s remarks make clear, however, that goal is not universally agreed to and the pass-through community needs to be on watch.
Good News on BIG!
In other Finance news, the Committee announced last night that it would mark up tax extender legislation tomorrow. You can read the description of the bill here, coupled with the score by the Joint Committee on Taxation. Major provisions in the legislation include:
- A one year extension of the AMT patch (2012);
- A two-year extension of the R&E tax credit (2012 and 2013); and
- Higher limits under Section 179 expensing (2012 and 2013).
The highlight for the S corporation community is the two-year extension of the shorter, five-year holding period for built-in gains. Extending the five-year period has been one of our priorities for the past year. The current, overly long ten-year holding period prevents companies from accessing their own capital at a time when capital is scarce. What make more sense than extending the more reasonable five-year period?
The bill announced yesterday does not include 18 provisions that had been previously extended by Congress, and more provisions could potentially be added or deleted tomorrow during the mark-up. So, there’s still a lot of work to do before important built-in gains relief is enacted into law.
Fortunately, we have plenty of allies in the Senate on this provision from both sides of the aisle — Senators Cardin, Snowe, Hatch, Landrieu, Grassley, and Roberts have been key advocates on this issue through the years — and we’ll be working closely with them to get this provision across the finish line! Stay tuned.
The budget introduced in the House today calls for a couple broad items on the tax front. First, it calls for extending all the tax provisions set to expire January 1st. That’s the rate cliff we’ve been warning S corporations about for the past couple months. Marty Feldstein made the case clearly this week in the Financial Times as to why Congress needs to act:
But the most important cloud on the horizon is the large tax increase that will occur next year unless legislation is passed to block it. The Congressional Budget Office predicts that, under current law, the revenue of the federal government will rise from $2.4tn in the current fiscal year, which ends in September, to $2.9tn in the following fiscal year. That increase of $512bn is equivalent to 2.9 per cent of GDP, bringing federal revenue as a share of GDP from 15.8 per cent this year to 18.7 per cent next year.
The higher revenue would reflect an increase in personal tax rates, higher payroll taxes, as well as higher taxes on dividends, capital gains and corporate incomes. Revenue would continue to rise in future years – as a share of GDP it would increase to 19.8 per cent in 2014 and would stay above 20 per cent for the remainder of the decade.
A sustained tax increase of that magnitude would push the US into a new and deep recession next year. So, it is important to recognize that legislation is required to prevent such a tax rise.
Second, the budget calls for comprehensive, budget-neutral reform of the tax code, with a goal of getting the top rates on both corporate and individual income down to 25 percent, fully offset by eliminating tax expenditures to broaden the base. Here again, the budget anticipates the concerns the business community has raised regarding tax reform. Recall our three key principles for doing tax reform right, endorsed by 45 business groups in D.C.:
- Make it comprehensive;
- Keep the top corporate and individual rates the same; and
- Continue to reduce the double tax on corporate income.
Where the Obama corporate-only reform plan failed each of these three principles, the reform outline included in the Ryan budget embraces each of them — its comprehensive, the top rates are the same, and it reduces the burden of the double corporate tax. Here are the major reform points from the budget:
- Consolidate the current six individual income tax brackets into just two brackets of 10 and 25 percent.
- Reduce the corporate rate to 25 percent.
- Repeal the Alternative Minimum Tax.
- Broaden the tax base to maintain revenue growth at a level consistent with current tax policy and at a share of the economy consistent with historical norms of 18 to 19 percent in the following decades.
Rates are the same, its comprehensive, and lowering the corporate rate helps to reduce the double tax on corporate income. Check, check, and check. Now this is what we were talking about.
S-CORP’s Crystal Ball
It’s tough to predict, particularly about the future. But we’ll try.
With the introduction of the House Republican budget today, the budget process in Congress appears to be done. Members of Congress and the media will fight over the details of the Ryan budget for the next couple days, and the House will have to vote on it next week, but those are mere trees. The forest is simpler. The President produced a budget. House Republicans produced a budget. The Senate will produce nothing.
That means no overriding statement of congressional priorities on spending and revenue. It also means no reconciliation instructions in the Senate, which means it would take 60 votes to move the tax legislation described above through that body, rather than 50 plus the Vice President if they were moving the bill as a reconciliation bill created by the budget resolution. Those ten votes make a big difference in the odds something could pass, and they pretty much doom the Senate to inactivity on tax issues until after the elections. They may have the votes for a small business extender bill — we hope so — but probably little else.
Lame duck session and another debt limit fight, here we come.
That’s the consensus in D.C. — lots of debate on tax issues but nothing actually happens until after the elections. After the elections, motivated by the pending expiration of all the current tax policies and the need to raise the debt limit again, Congress acts either in the six weeks between the elections and Christmas or, even more frightening, waits until early in 2013.
In the meantime, the business community looks to be stuck without the R&E tax credit, bonus depreciation, shorter built-in gains holding periods, and other small-business-friendly provisions that expired at the end of last year. Business owners will also have to plan for paying taxes in 2013 without knowing what those rates will be. Neither situation is healthy, and it’s bound to have an effect on hiring and investment decisions moving forward.
We hope we’re wrong, and that the House and the Senate take up legislation to address the business-friendly extenders and the expiration of all the tax rates soon. The sooner they begin discussing these challenges, the sooner they can come to a solution.
Buffett Rule Tax Score
The Joint Committee on Taxation released its revenue estimate for legislation implementing a version of the so-called Buffett Tax. This estimate is in anticipation of the Senate voting on this idea in the near future.
The bill, S. 2059, was introduced by Senator Sheldon Whitehouse (D-RI) earlier this year and would impose a new tax equal to 30 percent of a taxpayer’s AGI less a modified charitable deduction for taxpayers with incomes exceeding $1 million. The impact of the tax is phased in for taxpayers making between one and two million to avoid a massive rate cliff when somebody’s earnings rise one dollar from $999,999 to $1 million.
Even so, as S-CORP Advisor Tom Nichols pointed out in testimony before the Ways and Means Committee several weeks ago, taxpayers would still face marginal rates well in excess of 30 percent as their business incomes rose from $1 million to $2 million.
The score itself, $47 billion over ten years, is extraordinarily small for such a broad-reaching policy. There are a couple reasons for this. First, the most obvious reason is that most people making more than $1 million a year are already expected to pay a substantial amount of tax, particularly if marginal tax rates go up as scheduled under current law. (That tax burden doesn’t include their share of corporate taxes paid, either.)
The second reason is that the Alternative Minimum Tax (AMT) is already in place as a second tax code. It looks back at the tax burden of families and makes those whose tax burden is too low pay more. Sound familiar? We already have a Buffett Rule tax, and it’s broken – it reaches down and raises the tax burden not just on millionaires, but on families making $75,000 or less. Since the Whitehouse bill thresholds are not indexed, over time this migration into the middle class would happen with his bill, too.
The Obama Administration hinted in their budget documents and subsequent testimony that they would like to use the Buffett Rule tax to replace the current AMT. Their actual budget, however, includes neither the Buffett Tax nor a repeal of the AMT. This is a policy the President talks about nearly every day, yet somehow it didn’t make it into his budget proposal. The reason for this is simple math. There’s no way the revenues raised by the Buffett Rule could ever replace the revenues gathered by the AMT over the next ten years. As the Obama budget estimates, merely holding the AMT to its current size and reach reduces revenues by $1.9 trillion over the decade!
So what we have is the worst of all worlds – the Senate is considering layering on a third tax income tax (fourth really, if you include payroll taxes) onto the two we already have. All this despite the fact that the United States already has one of the most progressive tax codes in the world. It’s the movie “Animal House” all over again.
The Super Committee announced today that it will not produce any recommendations for Congress to act on next month. The markets are reacting badly, which surprises us. They should have seen this coming. Maybe they were hoping for some sort of signal that Congress can function and is prepared to deal with our ongoing fiscal crisis, but every signal we received for the past two months suggested the Committee was going to fall short.
Now that they have missed the mark, the question becomes, “What’s next?”
For the remainder of 2011, Congress needs to act on the tax provisions set to expire this year. That includes a broad package of tax items, including the larger AMT exemption, the R&E tax credit, and important to the S Corporation Association – the shorter 5-year built-in gains holding period. Also in play is the ongoing payroll tax holiday, the expiration of extended UI benefits, and the so-called “Doc Fix” to postpone pending cuts in Medicare reimbursements.
For next year and beyond, the looming issue confronting S-Corp is the expiration of the current tax rates coupled with the imposition of the new 3.8 percent investment tax, both of which will take place starting January 1, 2013. The net effect will be to raise the top marginal rate on S corporation shareholders from 35 percent to nearly 45 percent.
This sharp tax hike facing S corporations is not the only “policy cliff” confronting folks on January 1, 2013. Also on the list is year one of the cumulative $1.2 trillion in spending cuts (sequestration) that were triggered now that the Super Committee has failed (including significant cuts to defense spending) as well as the need for Congress to raise the debt ceiling again.
All of which suggests Congress is going to have to do something big on the tax and spending front by early 2013, if not before. What would this package look like? There’s a short list of provisions almost certain to form the core, including:
- Debt ceiling increase together with another package of spending cuts;
- Extension of the expiring middle-class tax relief (lower rates, marriage penalty relief, refundable child credit, etc); and
- Extension of the AMT patch.
Beyond this core list, other possible (or likely) provisions could include an extension of upper income tax rates or some sort of broader tax reform, plus new spending cuts in exchange for reducing the pending defense cuts.
In response to this outlook, our goal is two-fold. First, work with our allies to get the provisions that expire this year, including the 5-year BIG holding period, extended into 2012 and beyond.
And second, organize the pass-through business community to make certain that Congress deals with the 2013 “rate cliff” in a timely and thoughtful manner. Congress is going to need to act, and the sooner we can educate policymakers on why, the better off we’ll be.
Does the debt deal include tax policies? Step One of the plan includes $917 billion in spending cuts only. But Step Two calls on a special “Joint Committee” to develop an additional package of deficit reduction that could include revenue provisions. Here are the details.
Under the plan, the new Joint Committee would be made up of six members each from the House and Senate, evenly divided between Republicans and Democrats. This Joint Committee would be asked to develop a package of deficit reductions equal to $1.2 trillion or more, and to report that package out by November 23rd. It would take a simple majority of Committee members to successfully report out a plan.
If the Joint Committee succeeds, then both the House and the Senate would have until December 23rd to vote on the plan. Under special rules, neither body would be allowed to delay or to amend the plan while a simple majority would be sufficient to adopt it.
If the Joint Committee fails in its task, or either the House or the Senate defeats the plan, then $1.2 trillion in across-the-board additional deficit reduction would be triggered. This sequester is spending reductions only, equally divided between defense and non-defense spending, with no revenues included.
Those are the details. What do we think? Based on our experience, the expedited procedures and sequestration rules included here are real and likely to result in additional deficit reduction of $1.2 trillion or more.
Will it include revenues? Both the White House and other Democrats have made it clear that revenues are “on the table” and that they expect to press for tax provisions as part of the Joint Committee’s product. In a blog post yesterday, National Economic Council Director Gene Sperling made the case for additional revenues:
The Joint Committee is tasked with deficit reduction, and the Committee can reduce the deficit by cutting spending and getting rid of tax loopholes and expenditures. Everything is on the table, as it should be.
First, the Committee can consider getting rid of tax expenditures like subsidies for oil and gas companies or corporate jet owners. These types of tax changes have been a major part of the recent deficit reduction conversation and would be a smart part of an overall balanced plan. No one on any side can dispute that the Joint Committee could consider them.
Second, the Committee can consider the kind of revenue raising tax reform that has broad and growing bipartisan support.
Director Sperling is correct that the Joint Committee can include tax hikes in the plan it presents to Congress if a majority of the Committee members vote to do so. But House and Senate Republican leaders have insisted that they would not nominate anyone to the Joint Committee who would support tax increases. Further, even if a Republican appointee does support a tax hike as part of the Joint Committee plan, that plan would have to pass both the House and the Senate. Why would House Republicans change their position to date and support higher taxes?
Remember, the alternative to the Joint Committee plan is an automatic, across-the-board cut of $1.2 trillion divided between defense and non-defense spending. Certainly, those defense cuts will be difficult for many conservatives in the House to stomach, but so much that they would embrace tax increases instead? We don’t think so. We believe the House will stick to its no tax hikes position and the Joint Committee will need to craft a package that avoids tax hikes if it wants the plan to pass Congress.
But what about budget neutral tax reform? Finance Committee Chairman Max Baucus (D-MT) is considering presenting a broad overhaul of the tax code to the Joint Committee for its consideration.
Again, although tax reform will definitely be part of the conversation during the Joint Committee’s tenure, we believe action is highly unlikely for two reasons. First, there’s simply not time. Tax reform is extremely complicated, and the Joint Committee has less than four months to complete its work. Chairman Baucus earlier indicated that it would take until the end of 2012 to write a comprehensive tax reform bill.
Second, tax reform in theory always enjoys broad support, but tax reform in particular means picking winners and losers. For every dollar of rate reduction, somebody loses a dollar of tax benefit. So tax reform would likely cost the Joint Committee votes it can ill-afford to lose.
So while the pass-thru community will need to be ready to defend Main Street businesses beginning this September, we don’t expect significant tax hikes or comprehensive tax reform to make it into the Joint Committee’s plan. That plan may include some offset tax provisions — – don’t forget, there’s a large package of tax provisions set to expire at the end of this year — but the broader fight over the direction of tax policy will have to wait for another vehicle.
What’s In a Baseline?
Behind the scenes of the debt limit compromise is a fight is brewing over the Joint Committee’s choice of budget baselines and what it means for tax policy.
While this might seem too trivial even for tax geeks, it could make a difference in the outcome of this process, and taxpayers should pay attention.
The question is, which baseline will the Joint Committee use to score its deficit savings — a current law baseline or a current policy baseline? Here’s the difference.
Under the current law baseline, the expiration of the Bush tax cuts in 2013 is considered the base case, so any effort to extend some or all of them would be seen as reducing revenue and increasing the deficit. Under this baseline, the Obama Administration’s proposal to extend just a portion of the Bush tax cuts would be seen as increasing the deficit.
Under the current policy baseline, those same tax cuts are expected to continue into the future, so any effort to roll them back would be seen as a tax hike but it would reduce the deficit. Under this baseline, the Joint Committee could vote to extend all of the Bush tax cuts except those affecting higher income taxpayers, and claim the resulting “savings” as part of their deficit reduction target.
Again, here’s Gene Sperling in his post:
The “baseline” is what deficit reduction is measured against. Reports have suggested that the Committee would have to use a “current law” baseline—a baseline that assumes that all of the 2001 and 2003 tax cuts expire along with relief from the Alternative Minimum tax. That would mean that any tax reform effort that raised less revenue than allowing all those tax cuts to expire would be scored as increasing the deficit. Even conservative Republican proposals for “revenue neutral” tax reform would be scored under this approach as increasing the deficit by more than $3 trillion.
However the claim that the Committee is required to follow this approach is simply false.
Is it? Here’s what the Budget Control Act says:
ESTIMATES.—The Congressional Budget Office shall provide estimates of the legislation (as described in paragraph (3)(B)) in accordance with sections 308(a) and 201(f) of the Congressional Budget Act of 1974 (2 U.S.C. 639(a) and 23 601(f))(including estimates of the effect of 24 interest payment on the debt).
And here’s section 308(a) of the Congressional Budget Act:
(a) 1 REPORTS ON LEGISLATION PROVIDING NEW BUDGET AUTHORITY OR PROVIDING AN INCREASE OR DECREASE IN REVENUES OR TAX EXPENDITURES.——
(1) Whenever a committee of either House reports to its House a bill or joint resolution, or committee amendment thereto, providing new budget authority (other than continuing appropriations) or providing an increase or decrease in revenues or tax expenditures for a fiscal year (or fiscal years), the report accompanying that bill or joint resolution shall contain a statement, or the committee shall make available such a statement in the case of an approved committee amendment which is not reported to its House, prepared after consultation with the Director of the Congressional Budget Office——
(A) comparing the levels in such measure to the appropriate allocations in the reports submitted under section 302(b) for the most recently agreed to concurrent resolution on the budget for such fiscal year (or fiscal years);
(B) containing a projection by the Congressional Budget Office of how such measure will affect the levels of such budget authority, budget outlays, revenues, or tax expenditures under existing law for such fiscal year (or fiscal years) and each of the four ensuing fiscal years, if timely submitted before such report is filed;
So, our reading of the just-passed bill suggests the savings that will count for purposes of meeting the Joint Committee’s deficit target are savings measured against a current law baseline.
Just for fun, consider the alternative. Say the Joint Committee used a current policy baseline and proposed to extend two-thirds of the Bush tax cuts. If the revenue impact of extending all the tax cuts was $3 trillion, then extending two-thirds would score as $1 trillion in deficit reduction for the Committee.
But the CBO uses the current law baseline for all its major budget reports, including its annual estimates of spending, revenues, and deficits. Under that baseline, extending two-thirds of the Bush tax cuts would increase the deficit by $2 trillion. So, the Joint Committee would have been tasked with deficit reduction, but by picking a more favorable baseline, its work would end up being scored as a deficit increase instead when the CBO updates its baseline next January.
Given the amount of scrutiny the CBO and Congress are under, it’s very unlikely the Joint Committee will choose to do anything but use the same baseline that Congress almost always uses – current law – and score any budget savings from there.
We don’t usually involve ourselves in spending debates but the President’s budget proposal came out this morning and, given the sea of red ink ahead, we thought a quick overview of the budget process and challenges ahead might be in order.
The President’s budget would reduce the deficit by $1.1 trillion over the next decade – two-thirds from spending cuts and one-third from tax increases. The proposed budget would trim or terminate 200 federal programs within the next year, reduce Pentagon spending by $78 billion, freeze non-security discretionary spending for 5 years, and increase spending in education, transportation and energy and medical research.
The budget also offers a 3-year paid-for patch for the Alternative Minimum Tax and calls on Congress to work with the Administration on budget-neutral corporate tax reform. Tax increases include allowing the 2001 and 2003 tax cuts for high-income earners to expire beyond 2012 and limiting the value of the itemized deduction for those same earners. Importantly, the budget does not include specifics on the President’s corporate tax reform proposal or any entitlement spending reforms. You can view the entire budget here.
The budget comes during a week when House Republicans are preparing to debate spending cuts included in the Continuing Resolution (CR) to cover government funding for the rest of the current fiscal year. These cuts are far below what was projected in the past – $100 billion below the President’s FY2011 request and $61 billion below FY2010 spending levels – and their success or failure will strongly signal how much deficit reduction is possible this year.
The debate itself should be lively as they will consider the CR in an “open rule” process where members will be able to introduce amendments on the House floor without getting them pre-approved. Considering the high level of interest from the freshman class and other conservative Republicans on this issue, we expect even more spending cuts proposed on the House floor through the amendment process.
Next up on the budget, House Budget Chairman Paul Ryan is expected to begin working on his budget resolution due in April. The rolling-out of the budget should overlap with the CR debate, as Senate Democrats have vowed to block the controversial cuts included in the House Republicans’ CR – placing at risk a potential government shutdown if a deal isn’t struck by March 4th when the current-law CR expires.
Most likely, short-term CR extensions will continue to pass until negotiators strike a deal. Further complicating the FY2012 budget process is the fact that we’re running up against the debt ceiling. Conservative Republicans are insisting on structural budget reforms, and potentially additional spending cuts as their price for support raising the ceiling, if they support it at all.
That debate is scheduled to take place in the April/May time frame, and while there’s a lot of random speculation about possible government shutdowns and defaulting on the debt, the simple fact is that Treasury has numerous tools at its disposal to keep things running until the Congress takes action, so we expect a negotiated compromise coming out of this process, not a budget crisis.
Back to the President’s budget, several folks have observed that the Administration chose not to follow the recommendations made by his Deficit Commission late last year, but that doesn’t mean the policies put forward by that group are dead. Senators Mark Warner (D-VA) and Saxby Chambliss (R-GA) are working diligently to advance the Commission’s blueprint. They are working with a broad group of 31 senators (including those who served on the Commission – Durbin (D-IL), Crapo (R-ID), Coburn (R-OK), and Conrad (D-ND). The group is shooting to put together legislation along the lines of the Commission report and have it ready by the debt-ceiling debate.
So we have lots of movement on spending and deficits, and we have three significant budget events overlapping in the next couple months – the CR funding the government for the remainder of this year, the budget resolution setting the spending and tax outline for next year and beyond, and the debt ceiling increase.
All of which suggests that by the time June rolls around, we’re going to have a really good idea whether Congress and the President are going to take real action and make progress to address the record deficits and fiscal crisis we face, or if, instead, gridlock will prevail and these issues will be pushed off until the 2012 elections. We’re voting for progress, but we’ll see.
Taxes in Budget and Rate Debate Ahead
We will spend the next year debating the details of the President’s tax policies included in the budget today, but here are some of the highlights that jumped out at us today:
- The budget calls for revenues over the 2012-21 timeframe to total $38.7 trillion, or about $1.3 trillion less than the CBO baseline. The difference is just about the same as the cost for extending the middle-class tax relief from the Bush tax cuts beyond 2012. Which means all the other tax cuts in the budget (the AMT patch, for example) are offset by revenues increases someplace else (curbing deferral for US multinationals, etc.)
- The President is sticking with past positions and arguing for higher tax rates on upper income taxpayers, beginning 2013, where the top rate on those families and businesses will rise from 35 percent to 43.4 percent. (Remember, that’s the year the health reform bill’s 3.8 percent investment tax and .9 percent Medicare tax take effect.) All of which suggests we’re going to relive the rate debate of last fall in less than two years.
- The President continues to press for taxing capital gains and dividends at 20 percent for upper income taxpayers. They are both at 15 percent for the next two years, with the dividend rate scheduled to return to 39.6 percent while the capital gains would revert to 20 percent in 2013. Again, this income would be subject to the new 3.8 percent investment tax, too, so the real rate for dividends and capital gains would be 23.8 percent.
- On the estate tax front, the President calls for returning to the 2009 rules of a $3.5 million exemption and a 45 percent top rate rather than either the current policy ($5 million and 35 percent) or the current law in 2013 ($1 million and 55 percent.) In an ongoing oddity, the budget again assumes the 2009 rules as part of the baseline, despite the fact that those rules are neither current law nor current policy.
- As noted above, the budget mentions corporate tax reform as something they would like to pursue, but does not include any details on how they might approach this, beyond that the reform should be budget neutral. Combined with the large increase in corporate taxes from reducing deferral and other provisions, it’s clear the President’s budget reflects a significant tax increase for both C corporations and S corporations compared to current policies.
- LIFO accounting is one of the “loopholes” to be closed under this budget. As Washington Wire readers know, we have been LIFO advocates for years and reject the idea that LIFO is a tax expenditure or a loophole. Nonetheless, it continues to be on the short list of provisions proposed by the President to be repealed in the future, either as part of corporate reform or outside of it. LIFO companies beware.