What’s Next?

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.

Super Committee — Running Out of Airspeed and Ideas

Just like an old pilot, the Super Committee appears to be running out of options in its race to find $1.2 trillion in savings. With one week left before the November 23rd deadline, time is short and the sides are far apart. There has been a measurable increase in activity and it’s obvious the Committee members are trying to cobble together something, but can they bridge the gap?

The lack of time for the Committee to act would suggest no.

The deadline for them to favorably vote on a proposal is November 23rd, but the real deadline is much sooner. Why? The Budget Control Act requires that the report must have been scored by the CBO and that the score must be available to the Committee members “48 hours prior to the vote.” Scoring a complicated spending and tax package takes time, so any proposed plan would have to be sent to the CBO by early this weekend if there’s going to be any chance the CBO will get an estimate put together.

So time is really short.

The sides remain far apart, too. Last week, we saw two competing offers, one from Senator Pat Toomey (R-PA) and one from Senator John Kerry (D-MA). The Toomey proposal was a $1.45 trillion package of spending cuts and higher revenues, of which the revenue increases would be packaged as part of an overall reform of both the individual and corporate codes — lower rates, broader base, etc. Parsing through the whole of the tax items, $250 billion would likely be counted as a tax increase.

Meanwhile, the Kerry proposal included more than $2 trillion in deficit reductions, $1 trillion of which were in the form of tax hikes.

Today, several sources are reporting that both sides have moved little since then. Republicans appear willing to go up to $300 billion, while the Democrats are bringing their bottom line number down to $800 billion. Here’s CQ:

Pushed hard by John Kerry - who sees this budget deal as his legacy-maker - Democrats are now willing to drop their revenue number to $800 billion (from $1 trillion) in a final attempt to get to a deal. But in return, they’re going to insist that entitlement curbs over the next decade be held to that new, lower number as well. And the Republicans are showing every sign they’re going to spurn that offer. Not only do they want to extract more from Medicare and Medicaid, but much more importantly, they also are already so far outside their own comfort zone with their stated willingness to go for as much as $300 billion in new revenues.

So the two sides are still $500 billion apart on revenues in a package that is supposed to cut the deficit by $1.2 trillion. Worse, Republicans are having an internal debate over what constitutes a tax hike and, more specifically, what constitutes a good deal. Here’s Politico on that:

On one side of the revenue debate are conservative Republicans like Hensarling of Texas and Sen. Pat Toomey of Pennsylvania, two members of the deficit cutting supercommittee, who are privately telling their colleagues that they aren’t abandoning their principles by raising several hundreds of billions in fresh revenue by closing loopholes, as long as Congress is able to lower tax rates across the board.

On the other side are conservatives like Sen. Jim Inhofe of Oklahoma, Rep. Patrick McHenry of North Carolina and roughly 70 House Republicans, who are adamantly opposed to the bulk of the revenue raisers proposed, warning it’s bad policy and politics, and could become a black eye for their party.

Republicans don’t have much room to move. Democrats want more than the $250 billion in new revenues Toomey put on the table in an offer last week and to drop calls for permanently extending the Bush tax cuts, placing the GOP in between Democratic demands and a loud conservative base frustrated at their party’s negotiators to offer a tax concession.

With all that in mind, we’re sticking to our guns and remain skeptical that anything substantive comes out of the Super Committee process. They could cobble together some sort of Rube Goldberg contraption here in the last couple days, but it’s doubtful. They also might adopt a smaller package of spending cuts. Apparently members have a list of several hundred billion in cuts that fails to touch any third rail issues.

But the effect of that package would be to swap one set of cuts (those under sequestration) with another. It doesn’t move the ball down the field towards additional deficit reduction or comprehensive tax reform. And that’s really the point of all this, isn’t it?

More Talk on Corporate-Only Reform

Congressional Quarterly has a really good article on the state of tax reform discussions on the Hill, and the Super Committee in particular. Here’s a few of the key paragraphs:

Advocates of a corporate overhaul argue that a lower corporate tax rate would help spur economic growth by improving the competitive position of the United States, which now has the second-highest corporate tax rate in the world, much to the chagrin of lawmakers in both parties. Moreover, with the unemployment rate hovering above 9 percent, lawmakers are eager to have the deficit panel take steps to boost the sluggish economy, even as the panel tries to write a $1.2 trillion deficit-reduction package by its Nov. 23 deadline.

Still, it would be difficult to pay for a significant rate reduction solely by eliminating tax breaks for companies. And raising more revenue than the government collects under the current tax system, as Democrats have demanded, also presents challenges.

Economists note that eliminating certain corporate tax breaks - such as the research and development tax credit and domestic manufacturing deduction - to pay for a lower overall rate could end up harming some industries that benefit significantly from the tax incentives.

In addition, there is a lingering problem, well-known to lawmakers, that many “pass-through” companies do not pay the corporate tax at all. Instead, they have their profits distributed to individual owners or partners, who are then taxed as individuals. Lowering the 35 percent corporate tax rate and eliminating industry-specific tax breaks without also lowering the 35 percent top individual tax rate could hurt those companies.

Concerns about putting one company at a disadvantage compared with another are precisely what give some lawmakers pause about settling for anything less than a rewrite of the entire tax system. Given those concerns, and Democratic hopes for more revenue from wealthier Americans, it will be hard for some lawmakers to abandon hopes of a complete overhaul.

Nevertheless, members of the deficit panel are trying to find a creative solution that would be fair to all types of businesses without major changes to the individual portion of the tax code, according to a congressional aide familiar the panel’s discussions.

Such efforts, which have yet to yield definitive, or public, solutions, are reflected in the comments from Hensarling and Ryan, who notably avoided terms like “corporations” and “corporate tax reform” in favor of “business-entities” and “business tax reform.”

This story confirms what we’ve been telling our members since January — there continues to be a strong interest in pursuing corporate or business “only” tax reform.

This time, the idea is to use tax reform to leverage cuts to entitlement programs. Democrats on the Super Committee have made clear that without tax provisions “on the table” they won’t agree to significant changes to Social Security, Medicare, or Medicaid. But there’s concern that reforming the entire tax code is simply too much. So the more narrow corporate reform is seen as the key to unlocking meaningful deficit reduction.

The challenges to this plan remain the same ones we’ve articulated in the past.  How do you construct corporate or business only reform that is budget neutral, or even raises revenue, without hurting specific industries, like manufacturing, or harming pass-through businesses? The lack of any particular plan — either from the Administration or the tax writing Committees — suggests these obstacles have yet to be overcome.

For guidance, an impressive group of 40-plus business groups‘ including the National Federation of Independent Business, the National Association of Wholesale Distributors, the Associated General Contractors, the American Council of Engineering Companies, the Independent Community Bankers of America, the S Corporation Association, and the National Restaurant Association, wrote tax writers earlier this week articulating three key principles to successfully reforming the tax code. These principles might not match up with the goals of some Super Committee members, but if you want to make American employers more competitive, they are a good place to start.

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