Obama budget contains tax provisions
April 11, 2013
President Obama released his 2014 budget plan earlier today, and as you might expect, it stands in stark contrast to the Republican budget offered up by House Republican Paul Ryan last month in terms of spending and projected tax revenue.
Ryan’s budget sought to completely eliminate the deficit by 2023. It did so by conceding no additional tax revenue over the next decade while slashing spending over that same period by nearly $5 trillion compared to currently budgeted levels.
President Obama’s proposal, however, makes no secret of its ambivalence towards balancing the budget. Instead, the President’s budget seeks to trim an additional id="mce_marker".8 trillion off the currently projected ten-year deficit of $6.7 trillion. This would yield a 2023 deficit of $439 billion, which would represent less than 2 percent of GDP, an amount many economists believe to be “sustainable.” The President would achieve these goals by replacing the current sequester with more carefully placed cuts that would trim governmental spending by nearly $2.4 trillion over the next decade while raising an additional $1 trillion in tax revenue from the nation’s wealthiest taxpayers.
On the tax side, the revenue raisers in the President’s budget appear to have been culled together from the cutting room floor of previous efforts, sort of like how I assume Michael Bay made Terminator 3. That is to say that there is nothing new among the President’s tax proposals; rather, they are simply reduces of previously abandoned or stymied efforts. But since they’re included in the budget, we can assume that the President will fight for them, so let’s take a closer look at the various provisions and their respective price tags:
Reduce the Value of Certain Deductions and Tax-Exempt Income to 28%
The President’s FY 2014 budget revived a proposal from FY 2013 — but not heard from much since — that would cap the benefit of certain deductions and exclusions at a 28% tax rate for those in marginal tax brackets in excess of the 28% bracket. Currently, individual taxpayers with taxable income in excess of $183,250 (if single) and $223,050 (if married) pay tax at rates of 33%, 35% and 39.6% on progressively increasing income. As a result, a taxpayer in the highest tax bracket generally gets a tax benefit of 39.6% for each claimed deduction; i.e., a charitable deduction of $1,000 gives yield to a $396 reduction in tax. (Note, this is before considering the application of the PEASE limitation, which reduces a taxpayer’s itemized deductions by 3% for each dollar adjusted gross income exceeds $300,000 (if married, $250,000 if single). PEASE was reinstated in the year-end fiscal cliff deal.
Under the President’s plan, however, taxpayers in the 33%, 35% and 39.6% bracket would only receive a tax benefit equal to 28% of a claimed deduction. To illustrate, in our example above, the taxpayer in the 39.6% bracket who makes the $1,000 charitable contribution would only experience a reduction in tax of $280.
It is very important to note, however, that this 28% limitation will apply not only to common itemized deductions – such as charitable contributions and mortgage interest – but also to two types of tax-exempt income that have long been considered the sacred cows of tax reform: employer provided health insurance and interest income on state and local bonds.
The approach appears to apply a tax rate to these items equal to the difference between a taxpayer’s top marginal rate and 28%. For example, a taxpayer subject to a top statutory rate of 39.6% would pay an 11.6% tax on tax-exempt income.While several provisions within the President’s budget are sure to incite controversy, I would anticipate that this proposed cap on tax benefits will angry up the blood the most. The Charitable Giving Coalition has already lashed out at the proposal, taking umbrage with the President’s characterization of the charitable contribution deduction as a “loophole.”
You can expect the individual states to follow suit, because the change in the treatment of tax-exempt interest will significantly increase the costs to state and local governments to fund their budgets, as the reduction in the tax preference will cause the interest rates on municipal bonds to increase, raising the states’ cost of borrowing.
Price tag: $529 billion in additional tax revenue over the next 10 years.
Imposition of the Buffett Rule
The need for a “Buffett Rule” – which would ensure that all taxpayers with adjusted gross income in excess of $1 million pay an effective tax rate of at least 30% — has been a popular rallying cry among the President and Congressional Democrats since the eponymous billionaire publicly stated that he paid a higher tax rate than his secretary nearly two years ago. More recently, the Senate showed us how the Buffett Rule Fair Share Tax would work when it floated a proposal to avoid the March 1st sequestration.
In simple terms, the President’s proposal would add another alternative minimum tax calculation to the current individual income tax regime. This alternative computation would put an end to the anomalous results experienced by the likes of Warren Buffett and Mitt Romney, who by virtue of the preferential 20% maximum tax rate afforded long-term capital gains and qualified dividends, pay effective tax rates in the low teens on tens or hundreds of millions of taxable income.
Price Tag: $53 billion in additional tax revenue over the next ten years.
Return the Estate Tax Parameters to 2009 Levels
The compromise between Republicans and Democrats on the expiring estate tax provisions as part of the fiscal cliff deal represented a victory for taxpayers. The estate tax exemption – set at $5.12 million in 2012 – was slated to revert to $1,000,000 in 2013 in the absence of Congressional action, while the estate tax rate would jump from 35% to 55%. While President Obama went into the negotiations hoping to split the difference with an exemption of $3.5 million and a 45% tax rate, he ultimately conceded a $5.25 million exemption amount and 40% tax rate for 2013. He also made those amounts permanent, with the exemption indexed for inflation.
Now, the President would like a mulligan. Beginning in 2018, the budget would return the estate tax parameters to 2009 levels: an exemption amount of $3.5 million (not indexed for inflation) and a 40% tax rate.
Price Tag: $79 billion in additional tax revenue over the next ten years.
Prohibit Individuals from Accumulating Over $3 million in Tax-Preferred Retirement Accounts
As a direct reaction to the revelation that Mitt Romney has stashed away enough cash in an IRA to purchase most of Eastern Europe, the President would limit the balance in a taxpayer’s tax-deferred retirement account to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, or approximately $3,000,000 for someone calling it quits in 2013. As Forbes’ Janet Novack says, limiting the amount that head honchos can put away for retirement may well trickle down and negatively impact employees.
Price Tag: $9 billion in additional revenue over the next ten years.
Tax Carried Interest As Ordinary Income
Private equity funds are currently largely taxed at preferential rates because they tend to generate long-term capital gains and qualified dividends — taxed as ordinary income, for two reasons:
1) The proposal would only generate approximately $16 billion over ten years, and
2) If you change the way profits interests are taxed, fund managers will simply find another way to be compensated that continues to afford preferential tax rates.
But as is often the case, I was wrong. The President renewed his position in the latest budget proposal, and would tax carried interest as ordinary income (though the proposal doesn’t state exactly how it would do so.)
Price Tag: $16 billion in additional revenue over the next ten years.
While these provisions are sure to draw the most attention, there are also some tax cuts to be found in the budget proposal. Specifically, the President would make permanent the expanded American Opportunity and Earned Income credits and extend through 2016 the current exclusion from taxable income for cancellation of indebtedness recognized on a primary residence. In addition, the budget would provide small business incentives in the form of a temporary 10 percent tax credit for increases in companies’ wages in 2013 over 2012 (available to businesses with less than $20 million of total wages for up to $5 million of increased wages) and extend the recently increased Section 179 limitations ($500,000 in 2013) through 2023.
On the corporate side, the President appears to be serious about corporate reform, as for the first time, he is not proposing to cut corporate loopholes as a means to reduce the deficit; rather, he would use any savings generated from base broadening to reduce the 35% corporate rate, currently the highest among industrialized nations.
Mentioned in the budget among those items on the President’s corporate to-do list is the expansion and simplification of the R&D credit, repeal of the LIFO method of accounting, and switching the current deferral regime of international taxation – whereby a U.S. corporation doing business through foreign subsidiaries generally doesn’t pay tax on foreign profits until they are repatriated to the U.S. — to a worldwide regime, where the same U.S. corporation would pay a minimum tax on the profits earned by the foreign subsidiary.
What does it all mean? As expected, Republican leaders termed the President’s budget dead on arrival, arguing that they sacrificed enough when they conceded $600 billion in additional tax revenue as part of the fiscal cliff deal. But the this should make for some interesting upcoming votes on the floor of Congress, particularly with several Democratic Senators up for re-election in 2014 in traditionally red states.