Let’s Make a Debt Deal!
On August 2, 2011, President Obama signed The Budget Control Act of 2011 (the Act) into law ending a political drama over an increase in the federal debt ceiling, at least for the moment.
While the so-called “debt deal” contained no tax increases, it set in motion a process by which some aspects of the tax reform debate may come into being. While some political observers may believe that Congress will not enact significant tax reforms just prior to or during an election year, provisions in the Act requiring mandatory across-the-board cuts will likely incentivize lawmakers to adopt some of the tax reform ideas as part of a deficit reduction package. This article will review the most significant recent tax reform proposals, including those contained in the “Gang of Six” report, after briefly reviewing key provisions of the Act that require deficit reduction.
The Act
Under the Act, the debt limit is increased by $400 billion immediately, and the President may obtain a further increase of $500 billion upon request. A subsequent increase of $1.2 to $1.5 trillion may be approved but only if Congress also approves net spending cuts of at least $1.2 trillion over the next 10 years. These cuts must take the form of a proposal developed by a “super committee” of lawmakers consisting of 12 members of Congress - 6 Democrats and 6 Republicans. The proposal must be passed into law by December 23, 2011, in order for increases to the debt ceiling beyond the initial $900 billion to occur. If the super committee fails to act in time, then the debt ceiling may be increased by another $1.2 trillion but “automatic” spending cuts of $1.2 trillion would be imposed and such cuts would fall equally on security and non-security programs (though Medicaid, Social Security, government employee pay and veterans programs would be spared).
The Prognosis
While the White House and several lawmakers hailed passage of the Act, many, including the President and a bipartisan group of six Senators (the Gang of Six), would have preferred to enact a more sweeping set of deficit reduction and tax reforms. The Gang of Six are: Dick Durbin (D-IL), Kent Conrad (D-ND), Mark Warner (D-VA), Tom Coburn (R-OK), Saxby Chambliss (R-GA) and Mike Crapo (R-ID). While this “grand bargain” could not be achieved it is likely that many of the tax reform elements of such a bargain will emerge again in the legislation to be proposed by the December 23, 2011 deadline imposed by the Act. For example, some of the key parts of the Gang of Six proposal may be resuscitated.
Under the Gang of Six proposal, tax rates for individuals would be lowered and existing tax brackets would be consolidated into three brackets with rates of 8-12%, 14-22% and 23-29%. The alternative minimum tax (AMT) would be eliminated, and a single corporate tax rate between 23-29% would be imposed, a significant reduction from the current tax rate of 35%. While these specific proposals would seem to decrease revenues, various significant tax expenditures would be curtailed. For example, the deduction for interest paid on debt incurred to purchase a home would likely be limited to interest paid on $500,000 of debt secured by a single residence. In addition, the deduction for charitable contributions would likely be reduced and deductions for tax-favored retirement vehicles would likely be reduced. Members of the super committee who seek a balanced approach to deficit reduction will probably resurrect some of the elements of the Gang of Six proposals.
But they will likely rely on other ideas as well. For example, a proposal to tax the so-called “carried interest” of private equity managers at ordinary rates will be part of the dialogue. As many observers have noted, the number one issue going into the 2012 election cycle continues to be job creation. As a result, we expect lawmakers to seriously consider a proposal to link a tax holiday on foreign-earned corporate profits to a fund for job training and creation. Other significant corporate tax proposals may form part of the debate including a proposal by business groups to change our approach to taxing foreign earnings to a territorial or “exemption” system. Under current law, U.S. corporations are subject to U.S. income tax on their worldwide profits and receive a credit for taxes paid to foreign governments on those earnings. Under an exemption regime, the U.S. would not tax foreign earnings at all (of course no credit would be available for foreign taxes under an exemption system). Business groups argue that an exemption system would put them on a level playing field as compared to their foreign competitors since many European countries have an exemption system (e.g., France, Germany and the Netherlands), and that this type of tax reform would enhance their ability to create domestic jobs by eliminating the incentive that exists under current U.S. law to keep foreign earnings offshore.
Given the current unemployment rate of 9.1%, a tax holiday for foreign earnings or even an exemption system may find their way into the super committee’s final work product in December along with one or more of the proposals discussed above. Taxpayers should follow the work of the committee very closely in the coming months because significant changes to the U.S. tax system may be right around the corner.
