Congress is back for the week, but we do not expect much to get done. House and Senate Democrats support allocating $25 billion from the Troubled Asset Relief Program to bailout the Big Three automakers, while the White House, Treasury and Congressional Republicans oppose expanding the program.
The auto bailout could be considered as part of a set of a broader economic stimulus package introduced by Senate Majority Leader Harry Reid (D-NV). We expect the Senate to take up some or all of the Reid Economic Recovery Act in the next couple days, with the House of Representatives stepping aside to see how the Senate debate proceeds. Combined, the Reid package includes:
- An extension of unemployment benefits for seven weeks;
- $38 billion in Medicaid assistance to states;
- $25 billion in loans from the TARP to the Detroit Three;
- An above the line deduction for families who purchase new cars;
- Increased Food Stamp, WIC, and food bank funding;
- Weatherization assistance and subsidies for clean car technologies;
- $5 billion for environmental cleanup;
- $13 billion for highways and other transportation;
- $4 billion or so for housing programs;
- $250 million for military housing;
- $2.5 billion for education and job training;
- $2 billion for NIH, CDC, and pandemic preparedness;
- An expansion of the SBA small business loan program;
- $1 billion for border security and homeland security;
- $675 million for federal science programs;
- Disaster assistance for farmers and communities; and
- Increased funding for consumer protection.
In addition to this long list, Senate Finance Committee Chairman Max Baucus would like to add several tax provisions, including extending bonus depreciation, suspending required IRA dispersals for account holders over 70 ½ years old, and easing pension funding requirements for companies.
While there’s a small chance something might get passed, we believe the stalemate over the auto bailout as well as other funding items is unlikely to get resolved in the next couple days and, as a result, readers should view this broad package as a precursor to Congressional action early next year.
TARP and S Corp Banks
As readers know, Treasury has now officially focused the entire $700 billion TARP fund to be used to inject capital directly into financial institutions under its voluntary Capital Purchase Program. Secretary Paulson has made clear the previously announced Whole Loan and Distressed Asset purchase programs will not be pursued.
For financial institutions organized as S corporations, this new focus presents a particular challenge. As structured, S corporation banks do not qualify for the CPP. According to our friends at the Independent Community Bankers of America, the terms of the CPP require the bank to issue special “preferred” shares in exchange for Treasury’s direct investment. But S corporations are precluded by the tax code from issuing preferred shares and thus are unable to access the CCP.
The Treasury is aware of this issue and is working on new rules that would apply to S corporation and other non-public banks. Part of this failure is simply the result of Treasury’s need to move quickly to restore confidence in the banking system. With 2,500 S corporation banks out there, however, it is an oversight that needs to be fixed.
The Treasury Department announced over the weekend that it would infuse $250 billion directly into the banking system, starting with approximately $125 billion targeted at nine major institutions including Goldman Sachs and Citigroup.
Combined with the coordinated efforts of central banks around the world, the announcement appears to have successfully staunched the record erosion of equity prices over the past two weeks. Interest rates and other indicators are moving in a positive direction as well, indicating that the credit markets may finally loosen up.
If you are keeping track, the latest move by Treasury is just the last in a remarkable and unprecedented list of actions by Treasury and the Fed to respond to the ongoing credit crisis. These actions include:
- $250 billion to recapitalized banks;
- $40 billion per month to purchase troubled assets;
- FDIC insurance raised to $250,000;
- Coordinated rate cuts around world;
- Inter-bank loan guarantees;
- $100 billion Fed intervention in repurchase agreement markets;
- Fed pays interest on balances;
- $300 billion to insure mortgages;
- Mark-to-market accounting changes; and
- Fiscal stimulus.
All told, it is about $2 trillion worth of liquidity, capital, and insurance backstops for the markets! Assuming it works and restores function to the credit markets — and we certainly hope it does — how all this will unwind is wholly unclear. It took a year for the Treasury and the Fed to reach this level of intervention. It will likely take several times that to get back to square one.
Another Stimulus Package Considered
There is more talk of a potential stimulus package. The most recent NFIB survey released today signals continued recession levels in America’s small business community. Meanwhile, today’s Politico outlines the possible response for Congress when they return November 17th:
A post-election session of Congress seems all but certain next month with House Democrats beginning to focus on more permanent tax breaks for middle- and working-class families, along with shorter-term spending proposals to stimulate the economy.
Treasury’s action this weekend reaffirmed what economists have been saying for months — the economy suffers from a lack of capital. Banks and businesses alike have seen their capital reserves dwindle in the past year to the point where investors worried about their solvency.
It is not $700 billion, but changing the rules governing the Built-in Gains tax would free up billions in locked up capital that could be used to build new plants, buy new equipment, and hire new workers — exactly what the economy needs right now. As S Corporation Association Chairman Richard Roderick wrote back in May:
According to government statistics, hundreds of thousands of S corporations nationwide may be sitting on “locked-up” capital that they cannot access or redeploy due to the prohibitive tax implications of BIG. This “lock-in effect” is widespread and results in these businesses unable to access billions of dollars in assets that could be used to grow the business and hire new employees.
If Congress does take up another stimulus package in November, we will be in there pushing for BIG reforms.
As equity markets continue their wild swings while the credit markets signal distress, Congress will make another run at the financial sector bailout this evening.
This time the Senate will try. The new package retains the core of the bailout — authority for Treasury to purchase hundreds of billions of dollars worth of troubled mortgages and other assets — while adding an increase in FDIC insurance levels from $100,000 to $250,000, hurricane relief, and the Senate-passed tax extender package.
The goal is for the Senate to pass this package with a strong vote and put new pressure on House members of both parties to support the bailout. The House needs at least 12 members to change their vote and support the package.
We are hearing that a significant number of House Republicans are prepared to support the bailout this time around. Those votes will be needed. The Senate extender package that passed the Senate 93-2 has focused opposition on the House side, including the caucus of moderate Democrats known as the “Blue Dog” coalition.
Blue Dogs oppose passing tax provisions without offsets, but they voted 26-21 for the failed bailout on Monday. How many of those 26 will switch and vote against this expanded package? Will increased Republican support be sufficient to offset Blue Dog defections?
House Leadership thinks it will, but then, House Leadership thought they had the votes on Monday too.
Effective Tax Rates
The Tax Policy Center has a new study comparing the effective tax rates under the Obama and McCain tax plans. According to the Center, the effective tax rate for taxpayers making more than $1 million stays the same under McCain (34 percent) but rises dramatically under Obama (45 percent if you include his payroll tax proposal).
We have pointed out in the past that fully one-third of all business income in this country is subject to the top two individual tax rates. Raising the effective tax rate on that income from 34 to 45 percent is going to harm small business creation and growth.
As Economist Greg Mankiw points out in his blog, higher tax rates also mean more dead weight loss to the economy, even if lower income taxpayers see their effective tax burden decline.
The deadweight loss of taxation rises roughly with the square of the tax rate. As a result, if one person sees the marginal tax rate fall from 20 to 15, while another sees it rise from 30 to 35, the average marginal tax rate is unchanged, but the deadweight loss increases.
In non-economist speak, that means a revenue neutral plan to balance tax cuts and higher government payments for low-income families with rate hikes on upper income families will result in less economic activity overall. That means less capital for investment and fewer jobs for workers.
Signs of recession are every where right now. The last thing Congress should consider is a hike in tax rates.
If you are following the markets, you might have noticed the financial sector bailout plan failed in the House, 216 to 206. Here’s the vote tally. When it become apparent the vote was going to fail, the Dow fell by more than 700 points (6%) and continues to trade in that range.
Your S-Corp team expects the House Leadership to work with the Administration to alter the plan and bring it back up on Wednesday. Possible changes include additional conditions for firms selling assets to the Treasury, a smaller cap on those purchases, etc.
Perhaps more to the point, changes will include anything and everything necessary to get 10 members of the House to change their votes. Expect another nail biter in a couple days. And then the Senate gets its shot.
The House is scheduled to vote on the financial sector bailout package later today. If it passes, the Senate will take it up on Wednesday.
The package itself retains the core Paulson proposal to give Treasury the authority to purchase $700 billion in problem mortgages held by banks and other financial institutions. The goal of the plan is to restore confidence in these institutions by eliminating this source of fear and uncertainty for the next two years. The ultimate cost of this plan to taxpayers will depend on how much further home prices fall. Some observers believe the taxpayer will be made whole when Treasury resells the securities.
In the past few months, we have seen the entire American investment banking industry disappear, the world’s largest insurance company fail, the largest failure of a bank in history, and Wachovia sold at a fire sale. Meanwhile, banks overseas are experiencing runs as well. Belgian giant Fortis was bailed out by European authorities this morning.
Opposition to the plan is now focused on questioning whether this plan will address the underlying problem — the lack of capital for our lending institutions and the pending run on our banks. One challenge for the plan as negotiated is it will take time for Treasury to begin buying these assets. Getting these assets off the banks’ books may help, but will it arrive in time?
Here’s some background material for those interested.
Observers expect the plan to pass both bodies, but it is going to be close. In the meantime, the world’s credit markets are watching very closely.
Extenders on Hold
At the beginning of the year, we would have bet money — serious money — that there is no way Congress would leave for the year without addressing the expiration of tax provisions like the AMT patch, R&E tax credits, and a long list of credits and deductions designed to encourage renewable energies.
The House is scheduled to take up yet another version of the energy extenders later today, and expects to adjourn for the elections shortly thereafter. The pending House action marks the six or seventh time this year that body has considered extender packages that include offsetting tax increases to cover the revenue loss.
The Senate has demonstrated repeatedly that it does not have the votes to adopt fully-offset extender packages, so why the House is taking yet another vote on this issue is unclear. Last week, the Senate passed a $150 billion package of extenders that included $25 billion in offsets. Both the Senate Leadership and the White House have communicated to the House that $25 billion is as high as they are willing or able to go.
The House action today suggests that if there is going to be an extension of these tax provisions before the end of the year, it’ll have to take place in a lame duck session. Now the question becomes, is there going to be a lame duck?
We are nearing the finish line for the 110th Congress with more on the table than when we started nearly two years ago.
None of the 12 bills to fund the government have been adopted. Tax provisions that expired at the end of 2007 remain to be extended. And the collapse of the subprime mortgage market that began a year ago with the failure of several hedge funds has grown into a full fledged credit crisis that, according to the Administration, threatens to harm the entire economy.
It appears Congress will stay in through next week and will have to address the following major items:
- A Continuing Resolution to fund the entire government through next March;
- A tax bill to extend expired and expiring provisions through 2009 and beyond; and
- Some form of relief to the credit markets, perhaps along the lines of what Secretary Paulson proposed last week.
Nothing like waiting until the last moment to start that really big term paper.
Some people believe you are not a real player in Washington tax circles until you have your own tax extender to worry over. If that’s the case, then your S Corporation Association has hit the big-time.
The S-Corp extender would extend for one year a provision that allows shareholders to deduct the full value of S corporation property they donate to charity. This provision, like all the other extenders, is caught in a battle of wills, with the House Democrats on one side and everybody else on the other.
Earlier this week, the Senate adopted a $150 billion package that included extensions of the AMT patch, the R&E tax credit, and the assorted energy tax provisions designed to encourage renewable energy. Over the last couple days, the House responded by passing separate bills to do the same thing.
The biggest difference in the two approaches is that the Senate package is offset with $25 billion in tax increases, while the House bills are offset by a total of $60 billion in tax increases. The horse traders in the room are probably thinking, “The Senate is at 25, the House is at 60. Let’s split the difference, pass the bill, and go home.”
But our intelligence is that both the Senate Republicans and the White House have made it clear that $25 billion in revenue raisers is as high as they are willing to go in this process — they would have preferred zero — and the House will have to take the Senate-passed bill or there will be no bill.
The Administration issued a veto threat against the House energy package, suggesting the House take up and pass the Senate bill instead. Whether House Democrats take the suggestion of a departing President remains to be seen.
Bailout Keeping Congress In D.C.
As we forecasted, the legislative wrangling over the bailout has been about as ugly as it gets. While we still expect a deal to get passed and sent to the President, there are several huge obstacles in the way and, while a deal this weekend is possible, action later next week is more likely.
The core of the plan being drafted in Congress is to give the Treasury the authority to purchase up to $700 billion in distressed assets over the next couple years. These assets are backed by subprime and Alt-A mortgages, are primarily held by banks and other financial institutions, and have undermined the ability of these institutions to continue their lending and other operations. Credit measures like Libor are signaling the threat Paulson outlined last week is becoming increasingly real.
If it works the way Paulson and Fed Chairman Bernanke suggest, the Treasury would purchase these assets at reverse auction for a competitive price, inject liquidity into the financial system while removing a considerable amount of risk and uncertainty, hold the assets until the housing market stabilizes, and then sell them back to the private sector. Observers much smarter than your intrepid S-Corp team — including Bill Gross and Warren Buffett — believe a properly executed plan would return a profit to the taxpayer.
The biggest obstacle to the bailout is the stand-off between Speaker Pelosi and House Republicans. The Speaker has made clear she will not move the bailout package unless a majority of House Republicans support it. But House Republicans — including their leadership and a substantial portion of their conference — have made it clear they oppose the current plan.
The solution is either that the plan changes enough to attract more House Republicans, or the Speaker moves the package without them.
- Here’s the latest Democratic draft reflecting the core proposal with numerous additions.
- Here’s the House Republican bailout principles released yesterday.
As you can see, there’s not a whole lot of common ground here. Republican Leader John Boehner just appointed the Republican Whip, Roy Blunt from , to represent House Republicans in future discussions, so talks will resume this afternoon and go into the weekend.
The question for S corporations is whether the dire predictions of the credit markets seizing up — affecting lines of credit, payrolls, etc — are realized before these talks result in some type of agreement.
Following a series of votes on alternatives, the Senate adopted a $150 billion package of tax extenders yesterday by a vote of 92-5. The key components of the package include:
- A one year extension of the higher exemption amount under the Alternative Minimum Tax. This provision will prevent about 20 million taxpayers from getting sucked into the AMT when they file their taxes this April.
- An extension of expired and expiring personal and business tax provisions, including the state sales tax deduction and R&E tax credit, though 2009.
- Several new provisions, including making the refundable child tax credit more valuable to low-income families and mental health parity provisions.
- Disaster relief for Hurricane Ike.
- A $17 billion package of energy extenders and new provisions, including an extension of the Section 45 production tax credit and a new credit for plug-in hybrid vehicles.
The big break-though was the decision by Senate leadership not to insist on offsetting the revenue impact of extending the AMT relief and other expired and expiring provisions. Of the total $150 billion revenue impact, only $42 billion is offset.
The package now moves to negotiations with the House, where its future is uncertain. The House today is expected to take up a smaller, $43 billion package of extenders fully offset with the same tax increases included in the Senate package.
All this action masks the fact that the underlying question remains the same — will House Democrats set aside their demand that all extensions of existing tax provisions be full offset, or will they accept the Senate compromise? With only a few days left before Congress leaves for the elections, we’ll know the answer in a couple of days.
Futures on Tax Rates
In the past, we have discussed how tax policy changes depending on who is the next President. Our assessment is that while there will be marginal differences, the final polices enacted under a McCain or Obama presidency will be more similar than not, with a strong bias for higher rates.
Greg Mankiw, former Chairman of the CEA, takes a more rigorous approach, but comes up with a similar conclusion. As posted on Greg’s blog:
What kind of tax policy will we get if John McCain is elected President? He says he wants to make the Bush tax cuts permanent. But is he likely to deliver that outcome in the face of a presumptively Democratic Congress? We can get some insight into this question using Intrade betting and some basic rules of conditional probability.
First, who knew the Intrade Prediction Markers tracked tax rates? Well they do, and using the current Intrade betting, Greg comes to the following conclusion:
That is, according to the Intrade betting, we are likely to see a significant hike in the top income tax rate even if McCain is elected President.
Estimating what will happen with the Treasury bailout plan is complicated by all the noise from Members of Congress expressing their opposition, advancing alternatives, and proposing additions like caps on executive compensation and changes to bankruptcy rules.
With a plan this large — and really, there’s nothing larger than giving Treasury $700 billion to save the economy – your S-CORP team prefers to step back and look at the forest.
Is the leadership in Congress willing to tell Treasury Secretary Paulson and Federal Reserve Chairman Bernanke “No” and take the risk — and responsibility — that the economy goes into free-fall? The answer is no, which means Congress will adopt some version of the Treasury plan with the core provisions intact.
The sausage making process will take a few days; it won’t be pretty, and many less than attractive provisions will be added to the legislation, but we believe it will get done.
By the way, Intrade agrees — the odds of Congress passing the package before the end of the month skyrocketed from yesterday’s close of 55 percent, to 80 percent this morning.
Our friends at the Treasury spent the weekend working primarily with the House Financial Services Committee to refine the Administration’s emergency plan to purchase hundreds of billions of dollars worth of mortgage backed securities.
According to Bloomberg, the scope of the proposal has expanded to include other troubled assets, including credit card debts and car loans. Members of Congress are also weighing in, seeking to add additional provisions such as limits on executive compensation and the cramdown of loan balances under bankruptcy.
The goal of these talks is to get a relief package through Congress and implemented before Congress leaves for the elections at the end of the week. As you can imagine, adding this 800 pound legislative gorilla to the existing long list of must-do items on Congress’ calendar has the potential to push the current session well into next week. At this point, Congress simply cannot leave without taking some form of action on this issue.
That’s not to say it’s a done deal. There is focused opposition to the expansive scope of the Treasury proposal that gives the Secretary of the Treasury unprecedented authority to purchase private sector securities and other assets. The broad nature of this authority should be viewed both as an expression of the enormous scope of the problem as well the size of the obstacle of getting it enacted.
How will this plan impact S corporations? A couple of thoughts:
Liquidity: The rational for the bailout is that the subprime contagion afflicting Wall Street was spreading to Main Street, infecting local banks and insurance companies and threatening your business’ line of credit, insurance policies, pension funds, retirement plans, and bank accounts. Presumably, the government purchase of these securities would cure the financial world and allow the sector to return to health.
It had better.
As we have discussed with our S Corp friends on the Hill and over at Treasury, after this plan, Treasury and the Fed will have used every tool they have, and several new ones they had to invent, in their efforts to restore confidence and order to the financial markets. Once some form of this proposal is enacted, there is no Plan B.
Tax Bills: While the ultimate cost of the proposed bailout to taxpayers is unclear (the taxpayer could actually see a profit when the multi-year process is complete) the initial cost of the plan will act as a massive drain on the budget.
A similar effect occurred during the Thrift bailout in the late 1980s and early 1990s. The ultimate cost of the bailout to taxpayers was around $150 billion, but Treasury had to spend many times that amount initially to pay off insured depositors of failed Thrifts. In later years, money from the sales of foreclosed properties resulted in revenues coming in to the Treasury. The net effect was a significant increase in deficits in the early years of the bailout and just as significant decrease in deficits as the process wound down
The deficit for 2008 is already projected to rise dramatically, from $161 billion to over $400 billion. Adding hundreds of billions of bailout expenses — or even a fraction of those costs, depending on how the CBO chooses to score the plan — will drive the deficit to records levels over the next couple years. These record deficits will squeeze Congress’ ability to move other priorities like extending portions of the Bush tax relief, stemming the growth of the AMT, or increasing federal spending for health care and other items.
The current setup reminds your S-CORP staff of the 1992 election, when candidate Clinton ran on a package of middle class tax cuts, but President Clinton pushed through tax increases instead. At the time, he argued that the deterioration in the budget made the tax hikes necessary. While there’s some debate over just how badly the deficit deteriorated between 1992 and 1993, there will be no debate next year. This bailout has the potential to double the federal deficit or more.
The net result is that once enacted, this bailout reduces the chances that Congress will act next year to reduce taxes or increase spending. The deficit, just like in the mid-nineties, will take center stage in budget and economic politics, placing additional pressure on tax rates to rise over the next couple years.