Fiscal (Slope) Cliff Forecast

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:

Top Rates

Worst Case

Best Case

Wage & Salary

44.7%

37.9%

Cap Gains

23.8%

15.0%

Dividends

44.7%

15.0%

Interest

44.7%

35.0%

S Corp Income

44.7%

35.0%

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:

More Likely

  • AMT
  • Middle-Class Tax Relief
  • Sequestration
  • Doc Fix
  • Tax Extenders
  • Extended UI Benefits
  • Upper Income Tax Relief
  • Health Care Reform Tax Hikes
  • Discretionary Spending

Less Likely

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.

Tax Outlook

With the Republican convention behind us and the Democratic one this week, we thought it would be worthwhile to assess what the business community can expect on taxes in the next six months. We break the outlook into three buckets:

  1. First, the need to extend the tax policies set to expire on January 1;
  2. Second, the need to make more fundamental changes to the tax code; and
  3. Third, what to do about those pesky tax “extenders?”

2001 & 2003 Tax Cuts

Bucket one is easiest, since both sides have outlined their positions. The Republican House adopted legislation to generally extend all the 2001 and 2003 tax policies for one year (together with expedited consideration of broader tax reform). One big deviation from previous Republican actions was the decision to extend current estate tax rules ($5 million and 35 percent top rate) rather than the repeal included in the original 2001 legislation.

Senate Democrats countered with legislation (which failed to muster the necessary 60 votes) to extend the middle-class portions of the 2001 and 2003 tax relief only. Investors, business owners, and income-earners making more than $250,000 ($200, 000 for single filers) would see their taxes go up. An exception in the Senate bill was the dividend rate, which would rise to 20 percent rather than the 39.6 percent rate called for under current law. Also, current estate tax rules were not extended, meaning the top rate would revert back to 55 percent next year coupled with a lower, $1 million exemption.

(Neither the House nor the Senate bill addressed the pending new 3.8 percent tax on investment income enacted as part of the health care reform, by the way.)

As to the outlook, the odds of either side prevailing in this fight depend heavily on the election outcome. The election won’t change any votes before next year — the President and Congressional leadership will stay the same — but moral authority plays a key role in moving legislation in lame duck sessions, so, if either side can declare a conclusive electoral victory, their respective position will gain momentum. That’s the positive outlook for action.

Inaction is also possible, however, and should be taken seriously. Several Senate Democrats are already on record arguing against taking any action this year — they say the fiscal cliff is more of a fiscal slope and that there will be time to address these issues in early 2013. Meanwhile, it’s difficult to see how House Republicans accept the Senate position and proactively vote for legislation that raises tax rates on anyone in this political and economic environment.

It’s also difficult to see how President Obama pivots off his current position and signs into a law a comprehensive extension. Finally, the inability or unwillingness of Senate Majority Leader Harry Reid to successfully move large, complex bills in the Senate is a particular challenge and should not be discounted.

For those reasons, we believe a Republican victory in November will signal that Congress will adopt something very close to the House bill — a one-year extension of everything coupled with some sort of expedited reform process — or, if the Senate and President stand firm, do nothing at all. If Democrats prevail, then the likely outcomes shift to either the Senate-debated position of extending just the middle-class relief or, if the House refuses to go along, nothing at all. So, regardless of who wins in November, there’s an even chance nothing gets done.

Additional variables that could affect the outcome include the pending sequestration cuts to defense and the strength of the economy. The worse the economy does, the more likely it is that Congress takes action, and vice versa. Meanwhile, the push by hawks and conservatives to stop the pending cuts to defense could result in them giving in other areas, including tax policy. Something to keep an eye on.

Tax Reform

Bucket two includes tax reform or changes to the tax code broad enough that they look like tax reform. We believe there’s a good chance Congress will act on such a package beginning early next year for the following reasons:

  • It will need to raise the debt limit (again);
  • There’s broad agreement that the deficit needs to be addressed;
  • There’s agreement that our corporate rate is too high; and
  • The annual game of extending all these tax provisions, including rates, the AMT patch, estate tax parameters, and traditional extenders is simply unsustainable and needs to end.

Put another way, Congress will need to raise the debt ceiling sometime early in 2013. To get the House on board, significant spending cuts will need to be part of the package, just like in 2011. To gather additional support, particularly in the Senate, taxes will also need to be part of the package. This tax package could be budget neutral, or it could raise significant levels of revenue. The elections will largely determine that mix.

Let’s say the President and Congressional leaders agree to raise the debt limit coupled with $4 trillion in deficit reduction over the next ten years. An Obama Administration and Democrat-run Senate might seek a 50-50 package of spending cuts and tax increases. A Romney Administration coupled with a Republican Senate might shoot for 100 percent spending cuts. Compromises necessary to move the package through the Congress under either scenario would argue that the final package will fall somewhere in between.

What sort of base-broadening might apply? Likely groupings include:

  • Previously targeted business tax items like LIFO, Section 199, and carried interest;
  • Traditional extenders that fail to gain sufficient support; and
  • Individual tax expenditures, including at least some portion of the exemption for employer-provided health insurance.

So, broad tax changes are likely to be on the table in 2013. A revenue-neutral package would broaden the tax base by eliminating certain tax expenditures and unpopular provisions and use all those revenues to cut rates, while a tax-increasing package would do the same, but cut rates to a lesser degree. As long as the House remains in Republican hands, a package that actually raises headline rates is highly unlikely.

Could Congress get through 2013 without considering broad tax legislation? It’s unlikely but possible, particularly if the Senate remains under Democratic control. The Senate has refused to act in other critical areas in recent years, like doing a budget. But just as the debt ceiling fight forced the Senate’s hand in 2011, we expect the same dynamic to play out in 2013. A budget resolution is optional; raising the debt ceiling is not.

Tax Extenders

Bucket three is the large list of tax extenders, many of which already expired at the beginning of the year. Both the Ways and Means and Finance Committees have taken action to define and adopt a package of tax extenders in recent months, but the ultimate outcome remains unclear.

Just prior to the August break, the Senate Finance Committee adopted legislation to extend a package of expired or expiring tax extenders through 2013. The $205 billion package includes a two-year AMT patch together with an extension of the state sales tax deduction, the higher Section 179 expensing amounts, the R&E tax credit, and the energy production credit and other energy incentives, among other items. Importantly for Washington Wire readers, the package also extends built-in gains tax relief and the basis adjustment for S corporations making charitable contributions of property. The Committee report and legislative language were released last week.

In a foreshadowing of the fight to come this fall, Committee leaders noted that their extender package deleted 20 provisions from extender packages of prior years, while several dissenting Republicans argued that the Committee should have gone further and that they look forward to further reducing the list as part of comprehensive tax reform. Senate leaders are hopeful to consider this legislation on the Senate floor in the few remaining legislative days before the November election, but it’s a full schedule already with only a few days of session.

On the House side, the Ways and Means Committee began their examination of tax extenders back in April, when members had the opportunity to advocate on behalf of their favorite extenders. In June, a panel of tax experts testified on which is the best framework to test each extender provision and eliminate those that fall short. It is unclear if the Select Revenue Subcommittee will hold another hearing in September, but Subcommittee Chairman Pat Tiberi (R-OH) was reported as noting that the House will not act on its version of an extender package until after the November elections, not before.

At that point, the tension between considering an extenders package separately this year or rolling these decisions into a broader tax reform package will have to be addressed. Given that Congress also will face the broader issues of the 2001/2003 tax cuts, sequestration cuts, the FY2013 appropriations process and the rest of the congressional kitchen sink, there’s not a lot of time and continued broad disagreement over direction.

For that reason, we believe it is fifty-fifty that Congress acts on extenders this year, with success most likely tied not to policy, but rather to whether Congress is able to move on some of these other fiscal matters. Movement in those areas would suggest an agreement over extenders is also possible, while a stalemate on the 2001/2003 cuts, spending and sequestration might bleed into the extender debate.

Just to be clear, this is our outlook, but it’s not our preference. Here at S-CORP, our fingers are crossed that Congress returns after the election and resolves all of these critical tax questions. For the business sector, action and clarity are better than inaction and uncertainty, so let’s hope this year’s lame duck session does not live up to its name and is instead positive and productive.

Tax Policy and the “Joint Committee”

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.

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