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Thursday, September 22, 2011

Budget Control Act Increases the Debt Ceiling, Excludes Tax Law Changes


Just in time to prevent the country from defaulting on its financial obligations, Congress passed and the president signed the Budget Control Act of 2011. The act provides immediate relief from the debt ceiling (authorizing a $900 billion increase) and makes more than $900 billion in spending cuts over 10 years. It also prescribes expedited procedures for implementing another $1.5 trillion in deficit reductions, coupled with an additional increase in the debt ceiling of between $1.2 trillion and $1.5 trillion.

Conspicuously missing from the act is any mention of taxes. Although nothing in the act’s language prevents lawmakers from considering tax law changes or other revenue-raising measures, the structure of the debt-ceiling deal will make tax reform difficult to achieve.

The Nuts and Bolts
The Budget Control Act’s language is complex, but here are the basics:

Stage 1. As noted, the act calls for spending cuts totaling more than $900 billion over 10 years. It also authorizes an immediate, $400 billion increase in the debt ceiling, which is expected to last through September 2011, plus an additional $500 billion increase, which is subject to congressional disapproval. The act’s requirements for blocking the $500 billion increase were designed to make blockage unlikely: It would require a joint resolution supported by a veto-proof (two-thirds) majority in both the House and the Senate.

Stage 2. The act establishes a joint congressional committee charged with identifying up to an additional $1.5 trillion in savings. The committee will consist of six senators and six representatives, with an equal number of Democrats and Republicans from each chamber. It must make its recommendations (which require seven or more votes) and submit proposed legislation by Dec. 2, 2011.

Congress must then vote on the bill by Dec. 23, 2011 — without the ability to make changes and pursuant to expedited procedures. The act also requires Congress to vote on (but not necessarily pass) a balanced budget amendment to the U.S. Constitution by the end of this year.

Depending on the joint committee’s level of success, these additional savings will be coupled with an additional increase in the debt ceiling ranging from $1.2 trillion to $1.5 trillion (also subject to congressional disapproval by veto-proof resolution), which is expected to last until 2013. If the committee recommends, and Congress approves, between $1.2 trillion and $1.5 trillion in savings, the debt ceiling will increase on a dollar-for-dollar basis. So, for example, $1.3 trillion in savings would increase the debt ceiling by $1.3 trillion.

Failure to achieve at least $1.2 trillion in savings will trigger automatic spending cuts, beginning in 2013, coupled with a $1.2 trillion debt-ceiling increase. “Failure” means one of three things: 1) The committee fails to produce a bill, 2) Congress doesn’t pass the committee’s bill, or 3) the legislation produces less than $1.2 trillion in savings.

If automatic spending cuts are triggered, half will come from defense spending and half from domestic programs. Certain benefits are exempt from cuts, including Social Security and Medicaid. But Medicare spending (on the provider side) is subject to cuts. The amount of automatic cuts is equal to the difference between $1.2 trillion and any savings achieved by the joint committee.

The automatic cuts are designed to provide the joint committee and Congress with a powerful incentive to make a deal. The idea is that defense spending cuts are so unattractive to Republicans and domestic program cuts are so unattractive to Democrats that the bipartisan committee will do what it has to do to succeed.

Alternatively, Congress can avoid automatic cuts by passing a balanced budget amendment and submitting it to the states for ratification. But a constitutional amendment requires a two-thirds majority in both the House and the Senate, a threshold that’s not likely to be met.

What Does This Mean for Taxes?
Many Democratic lawmakers pushed for a debt-ceiling deal that provided a “balanced” approach — that is, a combination of spending cuts and tax increases — for reducing the deficit. The Budget Control Act says nothing about taxes. On the other hand, it doesn’t preclude the joint committee from considering tax law changes or other revenue-raising strategies in achieving its savings target. But the act’s structure creates some significant obstacles to tax reform.

One is that the bipartisan makeup of the committee means that at least one Republican member would have to vote for a tax increase. But even more significant is the “baseline” used to gauge the committee’s deficit reduction achievements.

The act establishes a “current law” baseline, which means that any savings must be measured under the assumption that the “Bush tax cuts” and certain other tax breaks (including alternative minimum tax relief) will expire as scheduled. In other words, the revenue bump that will occur when these tax breaks expire doesn’t count toward the committee’s deficit reduction goal.

For example, currently, the top marginal individual income tax rate is 35%, but that rate is set to go back up to 39.6% in 2013. If the committee were to recommend a three percentage point increase in the top rate, from 35% to 38%, that move would be scored under the act as a tax reduction, from 39.6% to 38%. To use a three percentage point tax rate increase to raise revenues, therefore, the committee would have to recommend a top rate of 42.6%, a highly unpopular move that would have little chance of success.

The committee can still recommend tax law changes that raise revenues. These might include eliminating loopholes, reducing certain deductions or creating new taxes, such as a national value-added tax. But it’s unlikely that it will recommend any changes that affect tax rates or tax breaks set to expire at the end of 2012.

Stay Tuned
The Budget Control Act relieves some of the pressure the debt ceiling placed on the U.S. economy. At the same time, it creates a great deal of uncertainty over how lawmakers will satisfy their deficit reduction mandate. Once the joint committee makes its recommendations later this year, we’ll have a better understanding of how the law may affect your financial and tax planning strategies in 2012 and beyond.

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