Congress and the Administration continue to move through the three-step dance necessary to come to closure on the debate over extending expiring tax provisions.

Step 1 took place two weeks ago when the Democratic and Republican leadership met with President Obama. The meeting didn’t result in any agreements, but it did move the ball forward when both sides agreed to appoint six negotiators to begin talks — Treasury Secretary Geithner, OMB Director Lew, House members Van Hollen (D-MD) and Camp (R-MI), and Senators Baucus (D-MT) and Kyl (R-AZ).

Those negotiators have been meeting regularly and any agreement they reach would act as the catalyst for Step 3.

Meanwhile, Congress completed Step 2 on Saturday, when the Senate failed to move forward on debate of legislation extending only the middle-class tax relief. Five Democrats joined all the Republicans in voting against closing out debate. This action followed a successful House vote on Thursday evening for the same policies.

What is the point of holding these votes, especially in the Senate, when time is short and the policy is not going to pass? Two reasons come to mind. First, they send a signal to the base — in this case the core liberal caucus in both the House and the Senate– that their leadership is pressing forward on their position. As the New York Times, the Wall Street Journal, and several other publications noted today, these Democrats are increasingly unhappy with the prospect of extending all the rates. According to the Washington Post:

Any deal cut between the White House and the GOP would have to be ratified by Democrats in Congress who are growing increasingly anxious about the prospect of voting to extend tax cuts for the rich along with breaks for the middle class.

Many in the House are particularly agitated by the ongoing negotiations and say they are not inclined to rubber-stamp a deal that does not win significant Republican concessions to extend unemployment insurance as well as a host of tax cuts that were created in the 2009 stimulus package and are set to expire.

The second, and probably more usefully, reason for holding these test votes is to provide a very clear signal as to where the votes are and will help guide the negotiators in their discussions.

So what’s the end game? There appears to be a growing sense that a deal is inevitable. As Politico reported today:

Democrats and Republicans appearing on the Sunday morning political talk shows all described or hinted at the same broad outlines for a deal: Expiring Bush-era tax cuts would be extended, probably for two years, and expiring unemployment benefits would be extended to cover Americans who have long been out of work during the deep recession. While Democrats sounded grudging in their support for such a compromise, GOP senators sounded more upbeat about the direction of the debate.

In such a deal, the tax package would likely include: 1) an extension of all the tax rates (we think one year is also possible), 2) a similar extension of the expired tax extenders package and AMT patch, and 3) (less likely, but still possible) some sort of agreement moving forward on the estate tax.

Overall, we think the odds of action this year are increasing — maybe to 60-40, or even 70-30. This is still no way to run a railroad, but at least there’s a light at the end of the tunnel, and we’re reasonably confident that it’s not just another train.

Movement on Tax Reform

Folks have been talking about the next wave of tax reform since 1986, so predictions about pending reforms are usually met with a high degree of skepticism.

But the combination of record deficits and poor economy makes it increasingly likely that Congress will consider a major reform in the next two or three years, even if they don’t want to — circumstances could simply force their hand. With that in mind, we’re paying more attention to ideas on how to comprehensively revamp the tax code and what it could mean to S corporations.

The final report of the President’s Fiscal Commission was released last week and, although it failed to gather the 14 of the 18 votes needed to be adopted, it is being taken seriously by policymakers nonetheless (it did receive majority support of commission members) and should not be dismissed out of hand.

On the tax front, the report proposes to reduce marginal rates on corporations and individuals alike (yea!) while proposing to increase the overall level of federal tax from the historic 18 percent of our national income to an unprecedented 21 percent (boo!).

Another area of concern is that the report calls for raising taxes on investment income — what conservatives refer to as the second layer of tax — back to regular income tax rates. So, the plan would have the top rate on individual income come down from 35 to 28 percent, but it would raise the taxes individuals pay on capital gains and dividends from 15 to 28 percent. Kind of a mixed bag.

Getting back to the rate debate, the fact that the commission recognized the need to reduce individual (including S corporation) rates is a small victory — it diverges from other recent reform proposals — and should be applauded. There’s a lot of economic activity being taxed in the individual code, and this plan recognizes this.

Meanwhile, the Senate Finance Committee held the second in a series of hearings on tax reform last week. The hearing’s witnesses included Dr. Douglas Elmendorf of the Congressional Budget Office, Dr. Thomas A. Barthold of the Joint Committee on Taxation, and Dr. Mark J. Mazur from the Department of Treasury.

This was an expert panel rather than an advocacy panel, so we didn’t see any new ideas, but there is a lot of useful data that will help guide future debates, including a new JCT report summarizing the Federal tax system from 1975 to today. You can watch the hearing at the Committee’s website. In particular, note the discussion on business structures around minute 50. Something we’ll be focused on in coming weeks.