(Excerpt from a client folio published by Morgan Stanley)
Senator Barack Obama’s electoral victory, complete with expanded majorities in the House and Senate, gives the Democrats control over the legislative and administrative processes for the first time since 1994. This has significant ramifications for the new Administration’s policies to deal with the economic crisis, as well as domestic priorities on taxes, health care, energy, the environment, labor relations, and trade.
Today, President-Elect Barack Obama will shift to presidential transition following many months of campaigning. He will have just 77 days to assemble a cabinet, set critical priorities, and prepare a federal budget (which must be submitted to congress by February). Though he has not discussed it publicly, these plans are well underway. The Obama team is actively discussing potential Cabinet selections and will soon begin vetting resumes for the estimated 7,800 presidential appointee jobs which must be filled – 1,177 require Senate confirmation – and finalizing a comprehensive blueprint which will guide the incoming president through the transition.
While it is certain that the Obama presidency will mark a stark contrast from the Bush years, what remains to be seen is how much external factors like the economic crisis will impact his first 100 days and beyond. The following examines what we are likely to see under an Obama administration on an array of pressing issues.
Tax Policy: Storm on the Horizon
A fundamental component of the federal budget is the level of revenues or taxes, a finite resource that has implications on individuals, business and the broader economy. Historically, tax revenue as a percent of GDP has averaged around 18.1 percent. Under current projections by the Congressional Budget Office, revenues will grow to about 20 percent of GDP by 2012, the end of the next administration, absent additional action. A key issue before the next administration will be the appropriate level and composition of federal taxation. An examination of the ideas presented during the campaign by Senator Obama provides insight into the answer.
There are two key drivers that will greatly impact the tax debate – the federal budget deficit and the expiration of the 2001 and 2003 tax cuts. Federal budget scorekeepers estimate the deficit for this year will be about $450 billion and could exceed $750 billion next year, after factoring in the recent cost of the economic rescue plan recently enacted. In addition, as the economy slows, predictions of future revenue collections will be revised downward, putting further pressure on the deficit and the level of revenues to run the government.
Against this backdrop is the fact that the current structure of the tax code is set to change dramatically as a long list of tax rates and tax credits will automatically expire December 31, 2010, creating a large built-in tax increase. Beginning in 2011, the following changes are set to occur:
- The top marginal tax rate for individuals increases from 35% to 39.6%
- The maximum long-term capital gains rate increases from 15% to 20%
- The top tax rate on dividend income increases from 15% to 39.6%
- The estate tax will be repealed in 2010 and then reappear in 2011 at pre-2001 high tax rates and low exemption levels
- Tax credits for children, education, and other incentives will expire or be reduced
Given these built-in changes, President Obama and Congress will face significant tax policy decisions. Underlying the decision process will be two competing philosophical views on the coming 2010 changes. Proponents of extending the 2001 and 2003 tax cuts argue that failure to act will “allow” a $1.5 trillion tax increase to occur. From a competing perspective, extending the 2001 and 2003 tax cuts would “cost” $1.5 trillion in lost revenue to the Treasury, highlighting the budgetary challenge of continuing the current tax structure into the future.
Faced with the reality of the current and projected fiscal pressures, Congress and President Obama are unlikely to agree on extending all of the expiring tax relief. Thus, the debate will center on prioritizing tax policies and engaging in a give-and-take exercise to find a tax structure that fits within the current fiscal and economic environment. Looking ahead, two overarching pressures will put opposing constraints on the outcomes – (1) the size of the deficit will limit the size and duration of any tax extensions or tax cuts and (2) a stagnant or recessionary economy in 2009 and 2010 will make it difficult to raise taxes too high or too quickly for fear of making the economy worse.
According to the Tax Policy Center, Obama’s tax plan would cost $2.9 trillion over 10 years. Hidden within these numbers are proposals to raise taxes on business by either eliminating “corporate welfare,” ending “incentives for companies to ship jobs overseas” or using “tax havens,” and/or raising payroll taxes.
The incoming Obama Administration will need to decide which proposals to enact and which proposals to put aside as a new budget is crafted. One theme that is prevalent in the Obama plan is the clear distinction between tax reductions for lower- and middle-income Americans and tax increases for individuals making $200,000 or more and couples earning $250,000 or more. For these taxpayers, the Bush tax cuts would generally expire and they would see higher taxes in the form of additional payroll taxes and the phase-out of certain deductions.
The following outlines the various tax proposals Barack Obama announced during the campaign:
Corporate Tax Rates
- No specific proposal to lower corporate tax rate
- Provide a tax credit to employers that increase the number of employees in the United States; maintain U.S. headquarters; and provide certain benefits to employees
- Make permanent R&D tax credit
- Provide a refundable tax credit of up to 50 percent of health insurance premiums paid by a small employer for health care for employees
Renewable Energy Production Tax Credits
- Make permanent the current tax credit for the production of electricity from renewable sources
Revenue Raisers/Tax Increases
- Tax offshore income and “tax haven abuse”
- Codify economic substance doctrine
- Tax publicly traded partnerships as corporations
- Tax the “carried interest” income from investment partnerships as ordinary income rather than capital gain
- Tighten rules on tax deductibility of executive compensation
- Raise capital gains rate to 20% (from 15%) for individuals earning $200,000 or more ($250,000 for couples)
- Eliminate capital gains for certain investments in a small business or start-up business
- Raise tax rate on dividend income – from a top rate of 15% to top rate of 20% — for individuals earning $200,000 or more ($250,000 for couples)
Marginal Tax Rates
- Make permanent lower income tax rates (10/15/25/28% rates)
- Restore top rates of 36% and 39.6% (unclear what income level threshold new rates apply)
Phase Out of Personal Exemption and Itemized Deductions
- Restore phase-out of personal exemptions and itemized deductions in 2009 and beyond (taxpayer earning $200,000 (single) or $250,000 (couple))
- Extend and index AMT exemption at 2008 levels (i.e., maintain current patch)
Savers Tax Credit
- Make the Saver’s Credit refundable and change credit to provide a 50 percent match of the first $1,000 saved in a retirement plan
Tax Benefits for Families
- Make permanent $1,000 per child tax credit and marriage penalty relief
- Expand Earned Income Tax Credit
- Expand child and dependent tax credit
- Exempt from the first $50,000 of income received by a senior/retiree
Mortgage Tax Credit
- Provide a refundable “universal mortgage credit” equal to 10 percent of mortgage interest paid up to a maximum credit of $800 for taxpayers who do not itemize
Worker Tax Credit
- Provide a refundable tax credit of 6.2% of the first $8,100 in wages to offset the current payroll tax
Estate Tax Rates and Exemption Amount
- Freeze 2009 estate tax exemption and tax rate levels — $3.5 million exemption and 45% tax rate
- Subject incomes above $250,000 to payroll taxes. (The new payroll tax would be between 2% and 4% and paid by both the employee and the employer like the current Social Security tax. All income is already subject to the 1.45% Medicare tax)
Temporary Proposals to Address Economic Slowdown
- Eliminate the tax on unemployment insurance for 2008 and 2009
- Allow penalty free withdrawals from retirement accounts (limited to the lesser of 15 percent account balance or $10,000)
- Provide employer tax credit of $3,000 per employee hired in 2009 or 2010 (credit would be refundable)
Observations on the Consequences of Obama’s Tax Proposals
As with most policy decisions, there are winners and losers from changes to existing tax policy. An examination of the details of the tax proposal can provide some insight into who may benefit and who may see tax increases under the different tax policy changes outlined above.
Corporate versus Pass-Through Entities – The current top corporate tax rate is 35%. Under the Obama plan, the top tax rate on pass-through income would increase to 39.6% or higher. Although corporate income is taxed twice (again when distributed as capital gain or dividend) the annual tax for pass-through entities could increase above that for corporations.
Domestic over International Businesses – Senator Obama has proposed to “tax corporations that ship jobs overseas.” Details of the proposal have not been provided, but multinational corporations could see a tightening or repeal of the current rules that allow tax on foreign earnings to be deferred until repatriated to the United States. This change would only impact U.S. multinational corporations that have earnings from foreign operations.
Cost of Capital – Senator Obama would allow the capital gains rate to return to 20% and the top rate on dividend income to increase to 20%. Thus, the after tax cost of investments would increase. The shift to more and higher corporate dividend payouts would likely end with the increased tax on qualified dividends.
Cost of Labor – Senator Obama would impose a new payroll tax (between 2% and 4%) on incomes above $250,000. The tax would be imposed on both the employee and the employer, increasing the cost of labor. However, some employers would qualify for the new worker tax credit (up to $3,000 per employee) for firms that are increasing their number of employees.
Housing Subsidy – The proposed new universal mortgage tax credit of up to $800 for non-itemizers would further expand the various subsidies in the tax code for housing.