Tax Policy Client Alert
November 2008
Authors:
Michael W. Evans
202.661.3807
www.klgates.com
The Impact of the Election on the Federal Tax Policy
Debate: Are You Prepared?
michael.evans@klgates.com
Patrick G. Heck
202.778.9450
patrick.heck@klgates.com
William A. Kirk
202.661.3814
william.kirk@klgates.com
Introduction
In 2009, the new Obama Administration and new Congress will face what many have called
“a perfect storm.” With the 2001 and 2003 tax cuts expiring, with congressional budget rules
effectively requiring additional tax revenues to offset the cost of new initiatives, and with
growing concerns about the overall health of the economy, about the shift of jobs overseas,
and about a host of other issues with tax policy implications, taxpayers are likely to see the
most significant tax policy debate in decades.
The Political Setting
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With the election of Senator Obama as President combined with the Democratic Congress
with larger majorities in both the House and Senate than exist today, there is new impetus
for the Democratic agendas in Congress, including in the tax arena. New presidents tend to
push major tax bills quickly to follow through on campaign promises and to take advantage
of the “honeymoon” period. If history is any indication, there is a significant chance that
major tax legislation will be considered early in 2009, at a pace much faster than the usual
pace of tax legislation.
The Impending Expiration of the 2001 and 2003 Tax Cuts
There will be overwhelming bipartisan support for extending, at a minimum, portions of
the 2001 and 2003 tax cuts that benefit middle- and lower-income taxpayers. But extending
even some of these tax cuts will be costly. For example, making the $1,000 child credit
permanent will cost $261 billion over the next ten years. Extending relief from the marriage
penalty will cost $81 billion. On top of this, Congress wants to limit the growing reach of
the alternative minimum tax, which will cost nearly $64 billion in 2008 alone to protect
25 million taxpayers from the AMT. The tax code contains dozens of other temporary but
worthy policies, like the research and experimentation tax credit and the deduction for
college tuition, that expire year-to-year and whose extensions will cost at least another $27
billion annually.
The next Congress may not approve all of this tax relief. But it will enact a substantial part.
A conservative estimate of the cost is at least $2 trillion (over ten years) – and it could be
as much as $4 trillion. On top of that, President-elect Obama will likely propose initiatives
to address health care, education, energy independence, and retirement security that will
necessarily involve changes to the tax code.
Pay/Go
Democrats are likely to maintain some version of the “pay as you go” budget rules which
require that the cost of tax cuts be offset by either tax increases or spending cuts. Given
that large spending cuts are unlikely, this means that the cost of extending tax cuts will have
to be offset, at least in part, by tax increases. Thus, there is likely to be an intense search
for politically palatable tax increases next year. Even if the economy continues to sputter,
President-elect Obama could decide that economic stimulus proposals should be considered
Tax Policy Client Alert
first, and that major tax increases are inconsistent with economic stimulus, but that will only delay tax increases, not
prevent them. Before too long into 2009-2010, the Administration and Congress will have to confront the impending
expiration of the tax cuts, and will require significant offsetting tax increases in an effort to reduce the deficit.
“It shall not be in order in the Senate to consider any bill, joint resolution, amendment, motion, or
conference report … that would cause a net increase in the deficit in excess of $10,000,000,000 in any
fiscal year provided for in the most recently adopted concurrent resolution on the budget unless it is fully
offset over the period of all fiscal years provided for in the most recently adopted concurrent resolution
on the budget.”
Section 315 of S. Con. Res. 70 (2008 Budget Resolution)
Other Tax Issues
The new Obama Administration will face other tax issues. More than 20 years after comprehensive reform of
the tax code in 1986, there have been calls to undertake another comprehensive reform of the tax system, most
notably in the 2005 report of the President’s Advisory Panel on Federal Tax Reform, and President-elect Obama
has said that he wants to reform the tax code to eliminate inappropriate “loopholes.” In addition, as is discussed
below, tax issues will be implicated by efforts to address health care reform, energy independence, and the shifting
of jobs overseas.
Questions
1. What will happen to individual tax rates?
Background. The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Act”) implemented
a phased-in reduction in the tax rates that began in 2001 and was accelerated by the Jobs and Growth Tax Relief
Reconciliation Act of 2003 (the “2003 Act”). The 2001 Act also added a new 10 percent tax bracket for a portion
of taxable income that was currently taxed at 15 percent. Without further congressional action, the 10 percent
bracket will disappear and pre-2001 rates will return in 2011.
Pre-2001 Rate
Structure
2001 Rate
Structure
Post-2010
-
10%
-
15%
15%
15%
28%
25%
28%
31%
28%
31%
36%
33%
36%
39.6%
35%
39.6%
Rate Structure
November 2008 | 2
Tax Policy Client Alert
Top Tax Rate
80
70
60
50
40
Top Tax Rate
30
20
10
0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
Proposals. President-elect Obama proposes to retain some of the 2001 tax cuts, but to allow the rate cuts to expire
for taxpayers earning more than $250,000 a year, thereby increasing taxes on income in part of the 33 percent
bracket and the entire 35 percent bracket. President-elect Obama would also eliminate income taxes for seniors
making less than $50,000 a year.
With respect to payroll taxes, President-elect Obama has proposed a refundable income tax credit of up to $1,000
per family to offset the payroll tax on the first $8,100 of earnings. President-elect Obama is also considering a
plan that would impose additional employment taxes of between 2 percent and 4 percent on those making over
$250,000, although this proposal may not start for at least a decade.
In Congress, House Democrats have made two proposals recently to increase top rates. First, Ways and Means
Committee Chairman Charles Rangel introduced tax reform legislation in 2007 that would raise $832 billion over
10 years by imposing a surtax of 4 percent on adjusted gross income above $200,000 and 4.6 percent on adjusted
gross income above $500,000. Second, in 2008, the House passed a war supplemental package that included as
an offset for increased veterans’ education benefits, a surtax of 0.47 percent on adjusted gross income above $1
million. That provision alone would have raised roughly $52 billion over ten years.
Assessment:
• M
ost taxpayers are unlikely to see an increase in their income tax rates since President-elect Obama’s proposal
extends existing rates for those making under $250,000. The top individual tax rates are likely to be higher than
the 2001-2010 rate structure, because a more Democratic Congress will not approve legislation to permanently
extend the 2001 top marginal rate cuts. Moreover, the tax burden on those making over $250,000 will likely be
greater in the years ahead if President-elect Obama’s proposed changes to employment taxes are also adopted.
There may be a political “ceiling” at 39.6 percent for the top individual income tax rate. Chairman Rangel’s proposal
reflects this reality, by maintaining an effective top rate of 39.6 percent in his tax reform measure.
• M
any taxpayers could see higher effective rates, particularly if lawmakers fail to repeal the overall limitation
on itemized deductions and the repeal of the personal exemption phase-out, both measures included in the 2001
Act. Congress is likely to retain these limitations and phase-outs in order to raise significant amounts of revenue
from higher-income taxpayers.
November 2008 | 3
Tax Policy Client Alert
• P
resident-elect Obama’s proposal to modify the cap on income subject to the Social Security tax could have the
effect of imposing a combined tax rate in excess of 40 percent on some of the highest income taxpayers. However,
that proposal is likely to face criticism not only from conservatives, but also from Democrats concerned that the
proposal would undermine the “social contract” aspect of Social Security – the link between taxes paid and the
insurance benefits received. The same concerns of undermining the “social contract” would apply to Presidentelect Obama’s proposal to rebate payroll taxes. Republicans would attack this as transforming Social Security
from an earned entitlement into a welfare program.
• W
hile the public debate might focus on the marginal rates, taxpayers should pay particular attention to proposals
to limit or eliminate exclusions, exemptions, deductions and credits. Such proposals might allow policy makers
to keep all marginal rates lower while increasing taxable income and tax revenue overall. Moreover, policy
makers could raise revenue through means that are less transparent. For example, policy makers could adopt
an alternative CPI that would yield tens of billions of dollars in additional revenue annually and would enable
them to avoid tougher choices.
2. What will happen to the alternative minimum tax?
Background. The individual alternative minimum tax (AMT) was established as part of the first major tax reform
law, the Tax Reform Act of 1969. This was after Congress discovered that 155 taxpayers with income above
$200,000 had paid no taxes at all. The purpose of the AMT, as described by the Senate Finance Committee in 1982
(when the AMT was revised and expanded), was to assure that “no taxpayer with substantial economic income
should be able to avoid all tax liability by using exclusions, deductions, and credits.”
The individual AMT applies at rates of 26 percent or 28 percent, to “alternative minimum taxable income”
(AMTI) above an exemption amount. AMTI consists of regular taxable income plus a series of preferences such
as deductions for state and local taxes, interest on tax-exempt bonds, and accelerated depreciation.
Because the AMT exemption amount is not indexed, the number of taxpayers that would be subject to the AMT
has been scheduled to rise dramatically, from 4 million in 2006 to 30 million in 2010, at which point the amount of
revenue raised from the AMT would have risen from $24 billion to $119 billion. What was once a “class tax” has
slowly morphed to be a “mass tax.” To limit the reach of the AMT, Congress has repeatedly enacted the so-called
“AMT patch” that temporarily increases the exemption. The 2008 “patch” expires on December 31, 2008, so it
needs to be extended for 2009 (and each year thereafter) to prevent the number of taxpayers subject to the AMT
from spiking dramatically.
Projected Number of AMT Taxpayers
With and Without Effect of 2001-2006 Tax Cuts
60
Current Law/Tax Cuts Extended
50
Pre-2001 Law
MILLIONS
40
30
20
10
0
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
YEAR
November 2008 | 4
Tax Policy Client Alert
Like the individual AMT, the corporate alternative minimum tax was established by the Tax Reform Act of 1969
and revised and expanded by the Tax Reform Act of 1986. The corporate AMT applies at a rate of 25 percent to
AMTI above an exemption amount. As for individuals, AMTI consists of regular taxable income plus a series
of preferences. Unlike the individual AMT, the corporate AMT does not appear to apply to a dramatically rising
number of taxpayers or raise a dramatically rising amount of revenue. Fewer than 1 percent of corporations pay
the corporate AMT.
Proposals. President-elect Obama has proposed to fix the AMT, basically by pledging to prevent the number of
AMT taxpayers from growing. In recent years, Congress has repeatedly enacted a one-year “patch” to prevent the
individual AMT from applying to more taxpayers. Essentially, a patch temporarily increases the exemption amount
to reflect inflation. The latest patch covered 2008 at a cost of $64 billion.
In addition, there have been major proposals to make permanent changes in the individual AMT. Senate Finance
Committee Chairman Baucus and Ranking Member Grassley introduced legislation, S. 41, to repeal the AMT. The
Chairman of the House Ways and Means Committee, Congressman Rangel, has proposed to repeal the individual
AMT but would deny the benefits of repeal to taxpayers whose incomes are in the top 10 percent, by subjecting
these taxpayers to a replacement tax of 4 percent.
There also have been more specific proposals to address the application of the AMT in particular circumstances.
For example, in 2008 the House passed a provision that would abate interest and penalties associated with the
application of the individual AMT to the exercise of incentive stock options.
Assessment:
• C
ongress will, at the very least, continue to provide a “patch” indexed to inflation to prevent more taxpayers from
becoming subject to the individual AMT.
• A
lthough full repeal of the individual AMT would significantly simplify the tax code, the associated cost makes
repeal highly unlikely unless undertaken as part of comprehensive tax reform. Although full repeal may be a
stretch, there is likely to be a serious effort to revise the individual AMT on a more permanent basis. The options
might include changing the budget baseline to assume an AMT fix or something like the Rangel proposal wherein
AMT would no longer be a concern for the vast majority of taxpayers.
• F
ixing the AMT problem suffers from several political drawbacks. First, the vast majority of taxpayers are
unaware they would be subject to the AMT absent the patch. Consequently, in addressing the problem, Congress
would be spending hundreds of billions of dollars to prevent a tax increase that most taxpayers do not know exists.
Second, most politicians have already demonstrated a willingness to approve the annual patch without offsets
making it difficult to spend real tax dollars in the future to address the AMT when there are other competing
priorities. Third, addressing the AMT has become a political “gotcha.” Only when policy makers come to terms
with the true implications of the AMT will the true problem be solved.
3. What is the outlook for the estate tax?
Background. The estate tax was established in 1916 and has remained in effect ever since. In 2000, the exclusion
amount was $1 million and the top rate was 55 percent. As part of the 2001 tax cuts, Congress gradually liberalized
the estate tax rules, increasing the exclusion and reducing the rates; in 2009, the exclusion will be $3.5 million
and the top rate will be 45 percent. In 2010, the estate tax is scheduled to be completely repealed, but only for
one year; in 2011, the changes to the estate tax, like other provisions of the 2001 tax cuts, are scheduled to expire,
and the estate tax is scheduled to revert to its pre-2001 version, with an exclusion of $1 million and a top rate of
55 percent.
November 2008 | 5
Tax Policy Client Alert
Estate Tax Rules
60
4,000,000
50
3,500,000
3,000,000
40
2,500,000
2,000,000
30
1,500,000
20
1,000,000
10
500,000
0
0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Year
Rate
Exclusion
Proposals. Estate tax proposals this Congress have included proposals to permanently repeal or dramatically
curtail the tax, a “2009 freeze” that would make the $3.5 million exclusion and 45 percent rate permanent, and an
alternative that would establish an exclusion of $2 million and a top rate of 55 percent. President-elect Obama
supports a 2009 freeze.
Assessment:
• W
ith the “yo-yo” years of 2010-11 fast approaching, when the estate tax is scheduled to go from close to its
current levels to full repeal and then to the much lower exclusion and higher rates of 2000, the new Congress will
be under great pressure to quickly establish a new set of rules to facilitate reasonable estate planning.
• A
2009 freeze is likely to have considerable support, with current supporters including President-elect Obama
and other Democrats such as Senator Carper (D-DE) and Congressman Pomeroy (D-ND). However, the more
Democratic Congress next year may increasingly support alternatives, such as the bill introduced by Congressman
McDermott (D-WA) to establish a $2 million exclusion and a 55 percent top rate.
• B
ecause the CBO baseline assumes a reversion to the 2000 system, even such seemingly moderate proposals as
a 2009 freeze have substantial revenue costs.
• L
ook for Congress to include reforms to the gift and estate tax rules to tighten perceived areas of abuse (i.e.,
family limited partnerships, valuation discounts) and to help offset the cost of higher exemption amounts and
lower rates.
4. How will capital gains and dividends be taxed?
Background. Over the past few decades, the tax treatment of capital gains has fluctuated. From 1921 to 1986,
capital gains were taxed at lower rates than ordinary income, generally through an exclusion of 50 percent or 60
percent. The Tax Reform Act of 1986 eliminated the differential treatment of capital gains, subjecting both capital
gains and ordinary income to the same top rate of 28 percent. Thereafter, the differential treatment of capital gains
gradually returned for individuals (but not corporations), as Congress raised the top rate for ordinary income but
not for individual capital gains.
After 1993, the top rate for individual capital gains remained 28 percent, but the top rate for ordinary income had
risen to 39.6 percent. In 1997, Congress reduced the tax rate for individual capital gains to 20 percent (10 percent
for capital gains which otherwise would have been taxed at the 15 percent individual income tax rate). The 2003
November 2008 | 6
Tax Policy Client Alert
Act reduced the 10 percent and 20 percent rates on capital gains to zero and 15 percent, respectively. The 2003
reductions are scheduled to expire at the end of 2010, when the tax rate for individual capital gains is scheduled
to revert to 20 percent.
Tax Rate for Capital Gains
30
25
Top Rate
20
15
Capital Gains
10
5
0
1980
1985
1990
1995
2000
2005
2010
Year
In lowering the capital gains rate in 1997 and 2003, Congress stated that economic growth cannot occur without
saving, investment and the willingness of individuals to take risks. Congress believed that by reducing the effective
tax rates on capital gains, taxpayers would be encouraged to increase saving and risk-taking. Moreover, Congress
believed that a reduction in the taxation of capital gains would improve the efficiency of the capital markets because
the taxation of capital gains upon realization encourages investors who have accrued past gains to keep their monies
“locked in” to such investments even when better investment opportunities present themselves.
Until 2003, dividends received by an individual were included in gross income and taxed as ordinary income. In
2003, the tax rate for dividends was reduced to 15 percent (zero rate for dividends which otherwise would have
been taxed at the 15 percent individual income tax rate). The 2003 reductions are scheduled to expire at the end
of 2010, when the tax rate for dividends is scheduled to revert to the same rate as that of ordinary income (top
rate of 39.6 percent).
In lowering the dividend rate, Congress recognized that placing different tax burdens on different investments
resulted in economic distortions. Because interest payments on debt are deductible, the tax code encouraged
corporations to finance using debt rather than equity and might put the economy at risk of more bankruptcies
during an economic downturn. Moreover, Congress was concerned that prior law encouraged corporations to
retain earnings rather than to distribute them as taxable dividends to shareholders who might have an alternative
and better use for the funds, creating further inefficiency.
Some critics argue that the tax cuts enacted in 2001 and 2003 increased income inequality, reduced economic
growth over the long run, and contributed to the reemergence of the substantial budget deficits. Warren Buffett
frequently mentions that his secretary, who earned $60,000 in 2006, paid a higher effective tax rate than he did for
that year. Mr. Buffett noted that he was taxed at a 17.7 percent rate while his secretary was taxed at 30 percent.
IRS data generally supports Mr. Buffett’s claim. For years 2003 through 2005, the top 400 individual income
November 2008 | 7
Tax Policy Client Alert
tax returns with the largest adjusted gross incomes reported average income of $170 million and paid an average
effective tax rate of 18.6 percent. In comparison, the 2006 married filing jointly tax rate for taxpayers making
between $15,000 and $61,000 was 15 percent, and the rate for those making between $15,000 and $124,000 was 25
percent. There is also concern in Congress that managers of private equity and hedge funds are taking advantage
of a “loophole” that effectively allows them to receive capital gains treatment on their income – a profits interest
in the fund commonly referred to as “carried interest.”
Proposals. President-elect Obama has proposed to retain the current capital gains and dividend rates for those
making under $250,000. For those in the top two income tax brackets, President-elect Obama would create a new
top capital gains and dividends rate of 20 percent. Further, he would tax “carried interest” at ordinary income rates.
However, President-elect Obama has proposed to create incentives for small businesses and start-up businesses, in
part by eliminating capital gains taxes on income from investments in such businesses.
Assessment:
• P
resident-elect Obama and the Democratic Congress are unlikely to extend the lower 15 percent tax rate for
capital gains and dividends for those making over $250,000. However, with President-elect Obama’s announced
position, it is increasingly likely that tax rates for investment income will not exceed 20 percent.
• A
s Congress reconsiders the appropriate tax treatment of capital gains and dividends, it will also address associated
issues like “carried interest” and a zero capital gain rate for small business startups.
• T
he upcoming tax debate might lead policy makers to consider alternative options for taxing capital gains and
dividends as they search for additional revenue. For example, the Joint Committee on Taxation proposed in 2001
that the complicated rate system for capital gains be replaced with a deduction equal to a fixed percentage of the
net capital gain. This recommendation would simplify the computation of the tax on capital gains and streamline
associated tax forms. Another alternative could involve an income exclusion for certain levels of capital gain
and/or dividend income for lower- and middle-income taxpayers.
5. Will the corporate tax rate be reduced?
Background. Presently, the top corporate tax rate is 35 percent. Although this rate is low by historical standards
and has not changed much since enactment of the Tax Reform Act of 1986, there has been a significant change
elsewhere, with many other OECD countries lowering their corporate marginal tax rates. The Treasury Department
recently concluded that within OECD the U.S. now has the second-highest statutory corporate tax rate. Thus, there
seems to be an emerging consensus that serious consideration should be given to broadening the base and reducing
the corporate tax rate.
On the other hand, in July 2008, the Government Accountability Office (GAO) issued a report reaffirming that
most corporations, including the vast majority of foreign companies doing business in the U.S., pay no federal
income taxes. During the eight-year period reviewed by GAO, 72 percent of foreign-owned corporations went at
least one year without owing taxes and the same was true for 55 percent of domestic corporations. According to
GAO, a possible explanation involves the use of transfer pricing which can allow companies to push their profits
into lower-taxed jurisdictions.
November 2008 | 8
Tax Policy Client Alert
Tax Rate
Tax
RateforforCorporations
Capital Gains
United States
United Kingdom
Turkey
Top Rate
Switzerland
Sweden
Spain
Mexico
Korea
Japan
Italy
Ireland
0
10
Central Government
Corporate Tax Rate
20
30
40
Year
Proposals. President-elect Obama has not specifically addressed lowering the top corporate tax rate. However, House
Ways and Means Committee Chairman Rangel made a lower corporate tax rate a key element of his tax reform plan,
proposing to reduce the top corporate tax rate from 35 percent to 30.5 percent, saying that this would “help American
companies stay competitive internationally.” Chairman Rangel’s and other proposals stress that the corporate tax
rate should not be reduced in isolation, but rather as a broad trade-off, similar to the trade-off at the heart of the Tax
Reform Act of 1986, in which the corporate rate is reduced but the corporate tax base is broadened commensurately
by eliminating or reducing tax preferences. Specifically, Chairman Rangel would achieve a 30.5 percent corporate
tax rate by repealing the LIFO method of accounting and the section 199 manufacturing deduction; significantly
limiting deferral; delaying the implementation of worldwide interest allocation; and increasing from 15 years to 20
years the 197 amortization period for intangibles.
Assessment:
• A
n opportunity may exist in the 111th Congress for lowering the corporate marginal tax rate in an effort to make
U.S. companies more competitive and to encourage innovation and job creation. Many tax experts and lawmakers
from both parties have called for lowering the corporate tax rate.
• A
reduction of the corporate tax rate is likely to be part of an overall proposal that offsets the cost of the reduction
by broadening the corporate tax base.
• T
he impact on any particular industry or company is likely to depend on the balance between the tax reduction
resulting from the lower rate and the tax increase resulting from broadening the base by repealing or reducing
business tax “loopholes” and/or tax expenditures.
6. Will Congress change the tax treatment of income earned abroad?
Background. The U.S. imposes a tax on the worldwide income of taxpayers subject to U.S. taxing jurisdiction. The
system has two principal ameliorating features. First, U.S. companies receive a tax credit for the taxes that they pay
to foreign countries on the income they earn abroad. Second, the foreign income of a controlled foreign subsidiary
of a U.S. corporation is deferred until the income is repatriated to the U.S. in the form of a dividend payment, except
for income that is considered “subpart F” income (i.e., interest, royalties, dividends, rents).
November 2008 | 9
Tax Policy Client Alert
The current system has been repeatedly criticized, for different reasons. On one hand, many Democrats, labor
unions and others have argued that the current system creates incentives for U.S. companies to shift jobs overseas.
President-elect Obama has expressed concern about “large companies [that] have managed to secure tax breaks or
to hide their profits in overseas tax havens and not pay any American corporate taxes at all.”
On the other hand, many Republicans, business groups and others have argued that the current U.S. tax rules make
it harder for U.S. companies to compete internationally, by subjecting U.S. companies (and foreign subsidiaries of
U.S. companies) to a complex set of rules that have the effect of imposing higher taxes than are imposed on their
international competitors.
“Some large companies have managed to secure tax breaks or to hide their profits in overseas tax
havens and not pay any American corporate taxes at all. Barack Obama will level the playing field for
all businesses by eliminating special interest loopholes and deductions … as well as by limiting the
ability of large multi-national corporations to use tax havens to hide income overseas.”
--Obama ’08 Tax Plan
Proposals. The blockbuster issue in the upcoming tax debate is deferral. President-elect Obama has indicated he
would move aggressively to reform international tax laws, including deferral. Senator Kerry and other lawmakers
support eliminating deferral altogether. Ways and Means Committee Chairman Rangel introduced legislation
proposing that deductions associated with foreign income be deferred until the associated income is repatriated.
The Joint Committee on Taxation estimates that the Rangel proposal would raise $106 billion over ten years.
In addition, several bills have been introduced that would address specific perceived abuses in the international
tax rules, including proposals to prevent “treaty shopping” under tax treaties, to tighten up the subpart F rules,
to curtail the use of “tax havens,” to change the characterization of business entities (e.g., whether an entity is
characterized as a U.S. corporation), and to change the treatment of royalty and financial services income under
the foreign tax credit rules.
Assessment:
• T
he Congress will closely scrutinize federal tax rules affecting international transactions, but is unlikely to
repeal deferral in the near term. A proposal to outright repeal deferral would be highly controversial, with most
Republicans and some Democrats opposing it.
• I f a full repeal of deferral falls short, as expected, there are likely to be alternative proposals to “tighten up” the
international rules. Indeed, that is what led to the enactment of subpart F in the first place.
• T
he limitation on expenses proposed by Chairman Rangel may be seriously considered. Other possible areas of
focus include subpart F income; tax treaties, particularly to curb behavior that may be characterized as “treaty
shopping”; tax havens; the operation of the transfer pricing rules; earnings stripping; and reinsurance.
7. What is the future outlook for tax extenders?
Background. Beginning in the 1980s, primarily for budget reasons, Congress increasingly began to make some tax
policies temporary. Typically, these are tax incentives targeted to a specific industry or activity. In recent years, as
budget pressures have intensified, the number of such temporary provisions that need to be periodically extended
has grown to the point that the most recent “extenders” bill contained three dozen provisions extending expiring
tax provisions, whose total cost was $27 billion (the ten-year cost of a one-year extension). Moreover, the process
of considering tax extender bills has become the dominant task of the congressional tax-writing committees. This
year, Congress waited until the last moment to address the package of tax extenders, many of which had already
lapsed. Even then, Congress had to attach the package to the emergency economic stabilization legislation to
secure the necessary votes.
November 2008 | 10
Tax Policy Client Alert
The extender tail now is wagging the tax policy dog. The leaders of the congressional tax-writing committees have
expressed frustration about this. In speaking on the floor of the House on a recent extenders package, Chairman
Rangel defined tax extenders as “when people want bills passed, but they put expiration dates on them in order to
hide the real cost of the bill...we have so much garbage in this bill that soon I hope someone would have the courage
to take a look at the tax bill that we have and strip it of the preferential treatment and get down to making the bills
that we want permanent, and those that should not be permanent, just to kick them out.”
Key Extender Provisions
Provision
Cost/10 yrs.
(in billions)
1-year AMT Patch
-64,108
R&E Tax Credit
-9,897
Leasehold, Restaurant, and Retail Improvements
-6,728
Subpart F Active Financing
-3,970
State & local Sales Tax Deduction
-1,742
New Markets Tax Credit
-1,315
Tuition Deduction
-1,223
Section 45 Energy Production Credit
-7,046
Section 48 Credit
-1,777
Advanced Coal Project Investment
-1,423
Coal Excise Tax
-1,287
Plug-in Vehicles
-1,056
Energy Conservation Bonds
-1,025
Energy Efficient Homes
-1,067
Other
-7,745
TOTAL
-108,592
Proposals. There have been a few efforts to separate particular extenders and either make them permanent or
extend them for long periods of time. In 2006, Congress made permanent a number of temporary pension-related
provisions as part of the Pension Protection Act of 2006. In 2007, Congress approved legislation, as part of the
bill to raise the federal minimum wage, extending the Work Opportunity Tax Credit, which had until then been
part of the various extenders packages, for four and a half years. President-elect Obama campaigned on a promise
to make the R&D credit permanent so that businesses can rely on it when making decisions to invest in domestic
R&D over multi-year time frames.
A number of bills have been introduced this Congress to make various extenders permanent. The bills that seem to
have the greatest support would make permanent the R&D tax credit, the adoption credit, the rules relating to the
subpart F treatment of active financing, the deduction for donations of food inventory, the exclusion for employerprovided group legal services, the depreciation treatment of leasehold improvements, the deduction for mortgage
insurance premiums, and the rules for deducting film production expenses. These bills seldom include specific
proposals to offset the cost of the permanent extensions.
November 2008 | 11
Tax Policy Client Alert
Assessment:
• T
here is likely to be an intensified effort to break out of the extenders box, by making some of the extenders
permanent, lengthening the duration of others, and letting some expire. Although this has been tried before and
generally has failed, the level of congressional frustration, with the need to repeatedly pass extender bills, seems
to be growing.
• I f the new Obama Administration and Congress begin to address issues such as education, health care, energy
independence, and competitiveness, many of these temporary tax extenders could find homes on larger policy
initiatives.
• T
he cost of making various extender provisions permanent is high. For example, the ten-year cost of making
the R&D credit, active financing rule, and sales tax deduction for non-itemizers permanent is $115 billion, $56
billion, and $37 billion, respectively. Consequently, many extenders are likely to remain temporary until the
deficit situation is addressed.
There is likely to be a continuation of the current situation, in which very few of the extenders are made permanent or
extended for long periods of time, while the rest remain part of annual period extender legislation. A compromise in
Congress is possible by either making some of the extenders permanent with offsets permanently closing loopholes
or conversely, temporarily extending some tax cuts with the offsets coming from temporarily closing loopholes.
To the extent that the congressional Budget Act’s “reconciliation” process is used to pass a tax bill, the use of
extenders is likely to increase, because revenue-losing provisions in that bill will be required under the operation
of congressional budget rules.
8. How will the new Administration and Congress address the tax code and energy independence?
Background. Over the years, Congress has established a series of tax incentives for energy production. Originally,
these incentives primarily were for the production of fossil fuels (e.g., the oil depletion allowance). More recently,
Congress has established tax incentives for energy conservation and for the production of energy from renewable
sources, such as solar, wind, and biomass. For example, in the Energy Policy Act of 2005, Congress established
new tax incentives for energy efficient homes and commercial buildings, residential and business use of solar power,
and vehicles that use alternative technology.
Proposals. During the current Congress, there was intense work on a package of tax provisions that would extend
and expand energy tax incentives. Generally, the package included extension (and, in some cases, expansion) of
production tax incentives for electricity produced from renewable resources (including biodiesel), investment tax
credits for advanced clean coal technologies (particularly those that demonstrate high levels of carbon sequestration),
production incentives for biodiesel and other renewable fuels, as well as a range of other incentives. The new
incentives included:
• bonus depreciation for placement of “smart” electric meters and grid systems;
• investment tax credits for solar, fuel cell technologies, and certain “green” properties;
• expansion of tax-free bonds for certain clean renewable fuels; and
• a new credit for “plug-in” hybrid vehicles.
The fully offset energy package was enacted as part of the Emergency Economic Stabilization Act of 2008. Many
of the provisions are of only short duration. The next Congress is likely to consider further energy tax incentives
through a number of legislative proposals, possibly including a substantial energy policy bill or the reauthorization
of the surface transportation bill.
President-elect Obama has made a specific proposal to invest $15 billion a year in alternative energy and “green
jobs” to stimulate the economy. It includes investments in renewables, including extensions of credits like those now
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Tax Policy Client Alert
in place for solar, biomass and other renewables as well as incentives for clean coal technologies and transportation
that uses non-petroleum based fuel.
Assessment:
• A
lthough energy tax incentives were recently enacted, the next Administration and Congress will seriously consider
additional energy tax incentives to help address dependence on foreign oil.
• T
here is likely to be a continuing debate about whether the cost of the energy incentives should be offset exclusively
by limiting tax benefits available to the oil and gas industries or instead should be offset, at least in part, by other
revenue-raising proposals.
9. What is the outlook for taxes and health care reform?
Background. The federal income tax system affects health policy in several ways, most significantly through the
exclusion of employer provided health insurance from taxable income. The tax deductions that are available to
individuals who purchase their own health insurance are currently not comparable to the tax deductions available
for employer provided coverage.
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Tax Policy Client Alert
Top Federal Tax Expenditures
(FY ‘07 - ‘11) (cost in billions)
Reduced Rate (Capital Gains & Dividends)
631.9
Healthcare: Exclusion of Employer Contributions
628.5
Pension Contribution Exclusion
607.3
Mortgage Interest Deduction
430.2
Exclusion of Capital Gains at Death
279.9
Earned Income Tax Credit (EITC)
234.9
Tax Credit for Children Under Age 17
201.3
Deduction for Charitable Contributions
187.0
Exclusion of Benefits Provided Under Cafeteria Plans
185.5
Deduction of State and Local Income Taxes
175.1
Proposal. President-elect Obama supports reforming the health care system by building on the existing employerbased system. His current plan does not explicitly rely on major changes to the tax code (e.g., limits on the exclusion
for employer-provided coverage and individual savings incentives) to expand health insurance coverage. He has
proposed a series of non-tax reforms of health care that include income-based federal subsidies and direct spending
programs to increase health coverage. President-elect Obama’s plan would, however, provide small businesses
that pay a share of employee health costs with a refundable tax credit equivalent to 50 percent of premiums paid
on behalf of their employees.
Assessment:
• P
resident-elect Obama and lawmakers intend to make health care a top priority. congressional Democrats will
pass a large expansion of children’s health insurance early in 2009 offset in part with significant increases in
excise taxes on tobacco products.
• C
ongress and the White House will begin work on comprehensive health care reform with goals to expand
coverage, improve quality and control costs. Congress is likely to advance proposals to expand tax incentives
for small businesses that provide health insurance for their employees.
10. Where will President-elect Obama and Congress look for additional revenue?
Background. The Tax Reform Act of 1986 dramatically expanded the tax base by eliminating or reducing scores of
tax preferences and otherwise closing so-called tax “loopholes.” However, since 1986, many new preferences have
been adopted, with the Joint Committee on Taxation calculating that there are now 170 “tax expenditures” in the
tax code. The GAO indicates that the cost of tax expenditures exceeded the cost of federal discretionary spending
for half of the last decade. In addition, many sophisticated taxpayers have developed techniques to significantly
reduce taxes in ways that some characterize as taking advantage of “loopholes” in the tax code.
While comprehensive tax reform is unlikely in the near term, President-elect Obama has said that he will “level
the playing field for all businesses by eliminating special interest loopholes and deductions” in an effort to broaden
the base and raise revenue. Senate Finance Committee Chairman Baucus and Ranking Member Grassley have
identified the $345 billion annual “tax gap” – the gulf between taxes legally owed and taxes actually collected in
a timely fashion – as a drain on the U.S. economy and as a source of revenue to pay for U.S. priorities. In 2006,
the rate of voluntary tax compliance dropped from 85 percent to 83.7 percent. Each percentage point drop in the
rate of compliance amounts to a $30 billion increase in the annual tax gap. Since 2001, the federal government
has failed to collect more than $2 trillion in legally-owed taxes. In addition to focusing on compliance to close the
“tax gap,” the Finance Committee has also aggressively looked at closing loopholes and other tax shelters.
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Tax Policy Client Alert
“The Tax Code is filled with corporate loopholes and preferential regulations that benefit a handful of
companies at the expense of the rest of the business community as well as ordinary people who are hit
with higher effective tax rates.”
--Obama ’08 Tax Plan
“Some complain that improving tax compliance will burden taxpayers and decrease their rights. But
what about the rights of honest, hard-working taxpayers who do pay the taxes that they owe? Increasing
our nation’s rate of voluntary tax compliance is going to take some ingenuity. It will take some elbow
grease. It is going to require a multi-faceted approach. It will require addressing services, enforcement
and technology.”
--Max Baucus, April 18, 2007
“When somebody says: Well, you have got to raise taxes… I say, no, you do not. Let us go after some
of this stuff. Let us go after these offshore tax havens. Let us go after these abusive tax shelters. Let
us go after this tax gap.”
--Senator Kent Conrad, Chairman
Senate Budget Committee
Proposals. Although President-elect Obama has spoken mostly in general terms about closing loopholes,
there are a number of specific revenue-raising proposals that have been proposed in Congress over the last two
years including:
• c hanging the rules for hedge funds and private equity funds, including treating certain types of publicly
traded limited partnerships as corporations and characterizing carried interest as ordinary income rather than
capital gain;
• repealing the section 199 manufacturing deduction;
• repealing or limiting tax provisions benefiting the oil and gas industries;
• repealing lower of cost or market and LIFO methods of inventory accounting;
• codifying the “economic substance doctrine” regarding tax shelters;
• further limiting deductibility of executive pay and curbing deferred compensation;
• c hanging tax laws affecting international activities, including delaying the implementation of worldwide
interest allocation, transfer pricing and eligibility for reduced treaty withholding rates based on residency of
foreign parent;
• changing the tax treatment of various financial products;
• making changes to clarify the classification of employees as independent contractors;
• increasing the amortization period for intangibles from 15 to 20 years; and
• increasing various excise taxes, such as on tobacco products, various aspects of air and highway transportation,
and tax-exempt organizations.
November 2008 | 15
Tax Policy Client Alert
Assessment:
• T
here will be an intense search by the new Obama Administration and Congress for ways to increase federal
tax receipts without broadly raising tax rates. Consequently, politically palatable revenue options that can be
characterized as “loophole” closers or proposals to reduce the tax gap will be high on the agenda.
• I t is likely that revenue-raising proposals will be embedded in major tax initiatives put forth by the new Obama
Administration and approved by Congress under the fast-track budget reconciliation process. These offsets will
be juxtaposed against popular tax relief measures making it politically difficult for adversaries to oppose them.
Conclusion
It is clear that the Obama Administration and Congress will engage in the most significant tax debate in a generation.
At stake will be important decisions regarding $4 trillion in tax law provisions, many of them set to expire in 2010.
Congress and President-elect Obama will wrestle over whether to extend, repeal or substantially modify scores of tax
policies that benefit every taxpayer. Undoubtedly there will be “winners” and “losers.” Under newly reinstated budget
rules, Congress will strive to pay for changes to the tax code and minimize additional debt. Since major spending
cuts are unlikely, the practical result will be a search for hundreds of billions of dollars in offsetting tax revenues.
The principal focus is likely to be on repealing so-called “tax loopholes.” Particularly at risk are tax provisions that
benefit perceived targets of political opportunity, such as large multi-national corporations.
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