The President’s Fiscal Blueprint for a Second Term and The Timing of Tax Changes
Written by Andrew Friedman Monday, 28 November 2011 00:00
Earlier this week President Obama released his annual budget plan for the federal government. In doing so, the President formally abandoned his promise, made in 2009, to cut the budget deficit in half by the end of his first term. This year’s plan calls for a federal deficit in 2012 of $1.33 trillion, higher than last year’s $1.3 trillion and close to the 2009 all-time high of $1.4 trillion.
Congress will not pass -- or even seriously consider -- the President’s budget plan this year. But the plan serves as a blueprint for the policies the President is likely to pursue if elected to a second term.
Spending: The President calls for total government expenditures in 2012 of $3.8 trillion, up from last year’s $3.6 trillion. Most of the additional spending would be devoted to new transportation and infrastructure projects and to initiatives to boost education, domestic manufacturing, alternative energy, and federal research and development. The new expenditures would be financed in part with a portion of the savings from ending the wars in Iraq and Afghanistan. (The remaining war savings would be applied against the deficit.)
The budget also calls for new incentives for domestic job creation, as the President highlighted in his State of the Union address. These incentives include a tax credit for new hires, an extension of the 2011 provision that permits an immediate tax write-off for plant and equipment investment, a tax credit for expenses associated with closing foreign facilities and moving the jobs to the U.S., and an enhanced tax credit for advanced manufacturing technologies. These incentives would be financed in part by eliminating tax deductions for expenses associated with moving operations abroad.
The President would reinstate the Build America Bond program and extend the eligible uses for BABs. States issuing BABs would receive an interest subsidy of 30% through 2013 and 28% thereafter.
Finally, the President proposes extending emergency unemployment benefits and the 2011 payroll tax cut (discussed below) through the end of 2012.
Taxes: The President reiterates his plan to allow the Bush tax cuts to expire in 2013 for families with annual income over $250,000 (individuals with income over $200,000).
Dividend taxes: In a change from his past position, the President proposes allowing the dividend tax rate for families with income above $250,000 (individuals with income over $200,000) to rise in 2013 to the new ordinary income tax rate.
In the past, the President had said he wanted to keep the dividend tax rate commensurate with the capital gains rate (raising both rates to 20% for high-income taxpayers). This change in position was predictable (indeed, I predicted it in the Q&As I released last week) given the President’s newly-expressed desire to ensure that wealthy individuals pay tax at the same rate as the middle class (the so-called “Buffett rule”, discussed below). Wealthy taxpayers tend to receive a significant amount of dividend income, which currently is taxed at a favorable 15% rate. Taxing dividend income at ordinary income rates will raise the average tax rate of the wealthy, consistent with the aim of the “Buffett rule.”
Limitations on tax deductions and exclusions: As he did in past budgets, the President proposes to limit to 28% the tax benefit of itemized deductions claimed by families with taxable income over $250,000 (individuals with income over $200,000). The proposal would work as follows. Suppose a family with taxable income over $250,000 earns an additional $10,000 and gives this additional amount to a charity. Under current law, the family’s tax essentially would not change, as the charitable contribution deduction would offset the additional income earned. Under the Obama plan, the additional income would be taxed at about 40%, but the charitable deduction would be limited to 28%, giving rise to a net tax of 12% on the $10,000, even though the taxpayer retained none of the funds.
For the first time, the President proposes extending the 28% limitation to above-the-line deductions and exclusions as well, including specifically tax-exempt interest income, retirement plan contributions, and employer-provided health care. Thus, for instance, a high-income family receiving $1000 of tax-exempt interest income would pay $120 tax on that income (12% of $1000).
How this rule would apply to retirement contributions is unclear, as retirement contributions are tax deferred, not excluded from tax altogether. At best, this rule would greatly complicate IRA basis computations.
In past years, the proposal to cap itemized deductions has made little headway on Capitol Hill, even among Democrats. It is unlikely to fare better in its expanded form.
Estate taxes: The President proposes returning the estate tax rules in 2013 to those in effect in 2009: a $3.5 million lifetime estate tax exemption (down from the current $5 million), a $1 million lifetime gift tax exemption (down from $5 million), and a 45% estate tax rate (up from 35%).
Other tax items: Other tax proposals would eliminate the “carried interest” rules that permit fund managers to pay tax at capital gains rates, eliminate oil company tax incentives (including the passive loss exception for working interests in oil and gas properties), and impose a new tax on financial institutions to compensate the government for the benefits they received under TARP and to finance a new mortgage refinance program.
Comprehensive tax reform: The President also calls for Congress to adopt comprehensive tax reform. The centerpiece of that reform would be the “Buffett rule” mentioned above, under which families with income over $1 million would pay tax at a minimum 30% rate. The “Buffett rule” would replace the current alternative minimum tax (AMT) regime. The $1 million threshold would be computed without the benefit of deductions, other than deductions for charitable contributions.
The President’s budget does not provide any details of how the “Buffett rule” would work. Normally, higher tax rates are applied on a marginal basis, that is, the tax rate is imposed only on income earned above a certain amount. But the President is proposing that families with income over $1 million be taxed at a 30% rate back to the first dollar earned. That implies that taxpayers with income of $1 million would bear the brunt of the rule on all their income while taxpayers with income at $999,999 would avoid the rule altogether, an inequitable result that is contrary to well-accepted tax policy.
In his State of the Union address, the President also proposed a minimum tax on the worldwide income of multinational corporations. This proposal might be fleshed out in a corporate tax reform plan the Treasury plans to release later this month. The corporate community has reacted negatively to this proposal, noting that a minimum tax on worldwide income would subject overseas profits to tax currently in the United States, even if those profits are not repatriated. Such a regime would place U.S. based multinational companies at a severe competitive disadvantage, as other countries have adopted a “territorial system” under which foreign earnings are not subject to tax in the company’s home country.
Payroll tax cut: The President’s budget plan reiterates his call for an extension of the lower payroll (Social Security) tax rate through the end of 2012.
The genesis of the payroll tax cut lies in December 2010, when the Republicans wanted to extend the then-expiring Bush tax cuts for another two years (through year-end 2012). To secure the President’s assent to that extension, the Republicans acceded to his plan to reduce the employee Social Security tax rate in 2011 from 6.2% to 4.2%. The President believes that the lower rate puts more money in workers’ pockets, which they will spend and help revive the economy.
At the end of 2011, the President asked Congress to extend the lower employment tax rate through 2012 as well. This demand put the Republicans in a box. Many Republicans do not believe that allowing workers to retain a small additional amount of their paychecks will actually grow the economy. Many also believe that it is not good policy to deplete the funds available for the Social Security program. But most important, Republicans simply do not want to support the President’s economic agenda in this election year.
However, Republicans have said repeatedly that they will not vote for tax increases, and that they view the expiration of a tax cut as itself a tax increase. So, in December, the Republicans grudgingly agreed to extend the payroll tax cut through February 2012.
Now Congress is discussing how to extend the cut through year-end 2012. The issue is not whether it should be extended, but whether commensurate changes should be made so that the cut does not add to the budget deficit. Democrats have sought to pay for the tax cut extension through higher taxes on the affluent. Until recently, Republicans have sought to pay for the tax cut through further cuts in government spending. More recently, however, Republicans have indicated a willingness to simply pass the tax cut without “paying” for it, thereby increasing the budget deficit. This change paves the way for the cut to be extended through 2012, at the expense of a higher budget deficit this year.
Congressional action on the Bush tax cuts: The Bush tax cuts -- the lower tax rates in effect for the past decade -- are scheduled to expire at the end of 2012. With Congress likely deadlocked until Election Day, the fate of the Bush cuts will be decided by a “lame duck” Congress convening between Thanksgiving and Christmas in 2012. The Congress that returns for that session will be the existing Congress -- a Republican-led House and Democratic-led Senate -- regardless of the election results. President Obama, too, will still be in office at the end of 2012: either he will have been re-elected -- feeling newly-empowered to enact his policies -- or he will be a lame-duck president who can do what he believes is right without concern for the consequences.
Republicans believe the Bush tax cuts should be extended for all taxpayers. Democrats believe they should be extended only for the middle and lower classes. President Obama has said he will veto any further extension of the Bush tax cuts for upper income families. If the President carries through on that threat, then either the Republicans must accept a compromise that raises taxes only on the affluent or watch the tax cuts expire for everyone. Under either scenario, affluent taxpayers will face higher taxes in 2013.
And that is not the end of the story. To help finance the health care reform law passed in 2009, Congress approved a new tax on investment income to take effect in 2013. Beginning next year, families whose overall income is above $250,000 (individuals with income over $200,000) will pay an additional tax of 3.8% on taxable investment income (e.g., interest, dividends, capital gains, rents, royalties). This additional tax will not apply to non-taxable income such as tax-exempt municipal bond interest, or to amounts withdrawn from qualified pension plans and IRAs.
When the new tax under health care reform is added to the expiration of the Bush tax cuts, in 2013:
- The top tax rate on ordinary income will rise from 35% to 43.4% -- an increase of almost 25%;
- The top tax rate on capital gains will rise from 15% to 23.8% -- an increase of almost 60%;
- The top tax rate on dividends will rise from 15% to 43.4% -- an increase of almost 300%; and
- The estate tax exemption will drop from $5 million to $1 million and the estate tax rate will rise from 35% to 55% -- an increase of over 55%.
Most important, Congress need not pass a single piece of tax legislation in 2012 for these tax rates to take effect in 2013. They will happen by default.
Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached at www.TheWashingtonUpdate.com.
Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
Copyright Andrew H. Friedman 2012. Reprinted by permission. All rights reserved.