Two new studies show just how hard a time Congress will have trying to slash tax rates without adding trillions of dollars to the budget deficit and producing a massive tax windfall for the highest-income American households.
Last week, the congressional Joint Committee on Taxation estimated that a tax plan that cuts individual rates to 10 percent and 25 percent and repeals the Alternative Minimum Tax would add almost $3.8 trillion to the budget deficit over 10 years. A plan to cut the corporate rate to 25 percent and repeal the corporate AMT would add another $1.3 trillion to the deficit.
Now the Tax Policy Center has looked at how the individual design would affect households in various income groups. Not only would such a rewrite dig a deep fiscal hole but it would also be extremely regressive. In 2015, it would cut taxes for those households in the lowest 20 percent of income (who will make roughly $25,000 or less) by an average of $3. By contrast, those in the top 1 percent (who will make an average of $2.1 million) would get an average tax cut of almost $145,000, a 10 percent boost in their after-tax income.
Middle income households (who will make an average of about $66,000) would get about $700, boosting their after-tax income by about 1.2 percent.
To put it another way, the top 20 percent of households would get nearly four-fifths of the tax cut. The top 1 percent would get more than half. ( Continue… )
What if state and local government deficits doubled over night and nobody noticed? That’s what happened last Wednesday when the Bureau of Economic Analysis released its comprehensive revision of the National Income and Product Accounts.
As my TPC colleague Donald Marron noted, the new BEA numbers downsized the federal government relative to GDP. They assigned economic value to intellectual property (such as a TV show about nothing). The numbers also brought about some soul searching on what GDP should be measuring.
But few people noticed that the numbers included a new measure of defined benefit (DB) pension obligations, which remain a big deal in the public sector even as most private employers have switched to 401(k)s. Largely because of this accounting change, what the BEA calls state and local government “net savings”– or the difference between current revenues and expenditures – fell from -$129 to -$252.7 billion.
Given attention to state and local pensions lately, especially in Detroit, one would think this news would have been met with cries of alarm or at least mild curiosity. But alas, no. That oversight is unfortunate because the new data shed light on an important issue.
Previously, the National Accounts measured DB pensions on a cash basis. The only spending that counted was cash out the door when employers made pension contributions. The only income that showed up for employees was pension fund dividends and interest. Promises of future benefits didn’t appear anywhere on the ledger, as household income or business and government expenses. ( Continue… )
Over the past week, Washington has been filled with news about tax reform—some reflecting necessary but painful truths and some just bad. In no particular order, here is where reform stands as Congress leaves town for its extended summer vacation:
Big rates cuts are very expensive. The congressional Joint Committee on Taxation estimated that Congress would have to eliminate trillions of dollars in individual and business tax preferences over the next decade to fully offset the cost of tax reform. JCT told senior Ways & Means Committee Democrat Sandy Levin (D-MI) that a plan to cut the corporate rate to 25 percent and trim individual rates to 10 percent and 25 percent and repeal the Alternative Minimum Tax would add $5 trillion to the deficit from 2014-2013. The Tax Policy Center reached a similar conclusion in 2012. In nearly all reform plans lost revenue would be made up by slashing deductions, credits and other tax preferences.
Dave Camp Speaks. In an interview with Bloomberg TV’s Al Hunt, House Ways & Means Committee Chairman Dave Camp (R-MI) acknowledged that he’s considering changes in popular deductions for mortgage interest and charitable gifts, and may favor taxing capital gains at ordinary income rates. While Camp did not say so explicitly, trimming the charitable deduction and boosting capital gains taxes are critical to any rate-cutting reform plan. These steps would not only raise needed revenue but also are necessary to prevent rate reductions from turning into a windfall for high-income households.
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Camp also said he’d try to mark-up a tax code rewrite by the end of the year and would consider tying reform to the coming battle over extending the debt limit—a fight that is likely to happen in November or December. Unlike President Obama, who backed a stand-alone corporate reform last week, Camp wants a combined individual/corporate package.
Electoral politics. 2014 Senate races increasingly intrude on tax reform, and not in a good way. Camp, who is term-limited out of his chairmanship of Ways & Means (absent a waiver by his caucus) is reportedly mulling a Senate race. Camp’s campaign would not be enhanced if he becomes identified as the guy who wants to cut the mortgage interest deduction. ( Continue… )
How much money do you make? Many Americans know what their wages and salary are. But they might be surprised to know that, on average, wages account for less than half the income of a U.S. household.
Others might pull Adjusted Gross Income off their income tax return. That adds sources such as business income; interest, dividends, and capital gains; alimony; and taxable Social Security benefits and pension distributions. Combined, they generate another 25 percent, but still leave out almost one-quarter of income.
Where does the rest come from? My colleagues at the Tax Policy Center have just completed a project that aims to better define income, which they call Expanded Cash Income, or ECI. It includes a lot of money that many of us might not consider income, but should.
For instance, employer-paid health insurance and other non-retirement fringe benefits add almost 7 percent to the average income of an American household. The employer share of payroll taxes bumps it up by more than 3 percent and employer contributions to retirement plans adds roughly another 1 percent. Combined, those employer-paid benefits and contributions boost our incomes about 11 percent, even though we don’t pay tax on that compensation.
Gross compensation is total comp before your employer subtracts benefits including payroll taxes. If your boss didn’t have to pay those taxes, your wages would be higher. ( Continue… )
In the week since Detroit became the largest U.S. city to declare bankruptcy, many commentators have speculated about what, if anything, this action means for the rest of the country. One narrative is that Detroit is sui generis – a city whose fiscal problems were long in the making, aided by broad macroeconomic forces and the city’s own political dysfunction. Indeed, Detroit’s previous mayor is in jail and several former officials, including a city treasurer, are under investigation for pay-to-play scandals at the city’s pension funds.
Another popular story line is that Detroit provides a glimpse into the future for states and localities where politicians made unrealistic promises to public sector workers and shifted the bill on to future taxpayers. A look at local pension finances across the country provides some support for this view. By their own math, locally administered pension plans had assets to cover 72 percent of their projected liabilities in 2011. However, this funded ratio dropped to 50 percent when future obligations were treated as more certain (like contracts, as state constitutions and some courts have required) and therefore on more equal footing with present day costs.
In Detroit, state appointed Emergency Manager Kevyn Orr has calculated the city’s unfunded pension liabilities at a whopping $3.5 billion. Pension costs have escalated even though the city eliminated more than 40 percent of its workforce (7,000 full time equivalent employees) over the past decade. One reason for this apparent disconnect is that pension contributions must cover both active workers and a portion of unfunded liabilities from the past. As a result, it can be very difficult for cities to get out from under a pension overhang.
Like other mainly Midwestern and Northeastern U.S. cities, Detroit used to be big, but now it is small. Its ratio of public sector workers to retirees has dropped from more than 3 at the end of the 1950s to less than 1 today. Cities like Chicago, Pittsburgh, and Baltimore also show big declines in their worker-retiree ratios.
This may sound a lot like the U.S. Social Security system. However, state and local pensions are not social insurance programs; they are part of public employees’ compensation packages (a fact underscored in today’s Comprehensive Revision of the National Income and Product Accounts). Because they are payments for services already rendered and consumed by current taxpayers, they are supposed to be at least partly prefunded, not financed on an ongoing or “pay-as-you-go” basis. ( Continue… )
At 8:30 yesterday morning, Uncle Sam suddenly shrunk.
Federal spending fell from 21.5 percent of gross domestic product to 20.8 percent, while taxes declined from 17.5 percent to 16.9 percent.
To be clear, the government is spending and collecting just as much as it did yesterday. But we now know that the U.S. economy is bigger than we thought. GDP totaled $16.2 trillion in 2012, for example, about $560 billion larger than the Bureau of Economic Analysis previously estimated. That 3.6 percent boost reflects the Bureau’s new accounting system, which now treats research and development and artistic creation as investments rather than immediate expenses.
In the days and months ahead, analysts will sort through these and other revisions (which stretch back to 1929) to see how they change our understanding of America’s economic history. But one effect is already clear: the federal budget is smaller, relative to the economy, than previously thought.
The public debt, for example, was on track to hit 75 percent of GDP at year’s end; that figure is now 72.5 percent. Taxes had averaged about 18 percent of GDP over the past four decades; now that figure is about 17.5 percent. Average spending similarly got marked down from 21 percent of GDP to about 20.5 percent. ( Continue… )
By doing so, Obama may have quashed the last shred of hope that tax reform can happen before the 2014 congressional elections.
In what the White House pitched as a new idea, Obama offered to decouple corporate tax restructuring from individual reform. This is odd since the president proposed stand-alone corporate reform as far back as 2012.
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His latest iteration doesn’t seem much different. Like his earlier plan, it would cut the top corporate rate to 28 percent from 35 percent and eliminate billions of dollars in (largely unidentified) corporate deductions and other tax preferences. But last year he called for revenue neutral reform (that is, a plan that would raise the same amount of money as the current corporate tax code). This time, he is pushing reform that would generate billions of dollars in new revenue, though it is not exactly clear how.
While the White House never quite says, Obama may want to pay for his jobs initiative with a tax on foreign earnings that multinationals return to the U.S. during a limited tax “holiday.” But those firms already owe 35 percent when they repatriate those profits. A special low tax of 10-15 percent, which is what he may have in mind, is not a tax hike, it is a tax cut. ( Continue… )
The First Circuit U.S. Court of Appeals ruled Wednesday that private equity funds are engaged in a trade or business under the Employee Retirement Income Security Act (ERISA). The court said the case, Sun Capital Partners v. New England Teamsters & Trucking, “presented important issues of first impression.” And the court’s resolution of the trade or business issue now may open the door to much higher taxes for private equity funds and their investors.
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In a unanimous decision, the First Circuit rejected the district court’s finding that private equity funds are merely “passive” investors, which is the position that nearly all private equity funds take for tax purposes. Under a typical fund’s partnership agreement, the fund must avoid engaging in a trade or business for Federal income tax purposes.
However, the First Circuit concluded that private equity funds that actively manage the operations of their portfolio companies are engaged in a trade or business. It does not matter whether a fund has employees or offices, or if its management company has the employees and offices. The key is whether the fund’s activities (including those of its management company) exceed those of a typical investor. That extra effort, of course, is the essence of private equity business and is used to justify the huge fees the funds charge their investors.
While the decision in Sun Capital means that private equity funds may be liable for unfunded pension liabilities of their portfolio companies, it potentially has much broader tax implications that are critical for private equity funds and their investors. For tax exempt or foreign investors, income from a private equity fund that is engaged in a trade or business is potentially subject to the unrelated business income tax (UBIT) or withholding taxes, respectively. Moreover the decision buttresses the argument that the income of private equity managers should be taxed at higher ordinary income rates, rather than capital gains rates. For more detail on this argument take a look at Tax Vox blogs here and here.
Now may be a good time for private equity funds, their managers, investors, and advisers to reexamine their tax position.
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Last week, the OECD proposed a major new initiative aimed at cracking down on tax avoidance by multinational corporations. The 40-page report follows widespread international criticism of aggressive tax planning by high-profile U.S.-based firms such as Starbucks, Apple, and Google.
The OECD report, called the Action Plan on Base Erosion and Profit Shifting, makes 15 recommendations including:
- Cracking down on transfer pricing, especially for intellectual property and other intangible assets. This practice allows firms to shift assets and expenses among its subsidiaries in a way that maximizes revenue in low-tax jurisdictions and maximizes deductible expenses in high-tax countries.
- Requiring additional transparency by firms. Companies would have to disclose their profits, sales, and taxes on a country-by-country basis.
The plan has already kicked off an important discussion. But chances of many of these proposals ever being adopted are slim. The OECD timeline calls for the group to gradually turn its framework into specific recommendations by the end of 2015. After that, each member country would have to approve the proposals for them to have the force of law.
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But critics are already chipping away. Even before the plan was released, the OECD backed away from even tougher rules proposed by French Finance Minister Pierre Moscovici. The OECD also rejected still more ambitious steps such as creating a system that apportions the income and expenses of a multinational among countries by formula based on economic activity in each individual country.
And, not surprisingly, big U.S. multinationals that benefit from the current international tax regime have already lined up against the plan. So have low-tax jurisdictions such as Ireland and the Cayman Islands. They insist they are not tax havens but don’t want the current system changed. Indeed, even as they object to aggressive tax planning many countries still encourage such tax-shopping. ( Continue… )
Detroit filed for Chapter 9 bankruptcy protection yesterday, giving it the dubious distinction of being the largest municipal bankruptcy ever. By doing so, the city has put its future—and that of its citizens, employees, retirees, bondholders, and other creditors– in the hands of a federal judge. How did the Motor City get to this sad place, and what will it mean for other cities?
How did this happen?
Detroit has been in decline since the 1960s, when auto plants began to close and the city started hemorrhaging jobs. Its population declined from 2 million in 1950 to less than 700,000 today. But the city was slow to reduce its public payroll, and its retiree obligations have exploded. The city has been spending about $100 million more than it’s taken in over the last five years. It currently has an estimated $18.5 billion in long-term liabilities—nearly half of which are for retiree benefits ($3 billion for pensions and about $6 billion for health care and other benefits)
Was this bankruptcy inevitable?
Probably. Last spring, the state appointed veteran bankruptcy lawyer Kevyn Orr to serve as the city’s emergency manager. But Orr was unable to convince creditors to work out the city’s obligations, and individual lawsuits have been piling up.
The crisis has been building for years. Not only is Detroit’s population shrinking, but those who stayed are older and poorer and thus need high levels of municipal services. The city struggled to provide those services while meeting prior obligations. ( Continue… )