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Legislative Issue Update - January 2008

[updated and expanded January 2008]

Tax issues were on the front burner throughout the first session of this Congress, and will remain so throughout 2008; but taxes are increasingly being discussed in the context of a slowing economy rather than in the abstract. The economic slump has prompted discussions again among political leaders and economists about whether to jump-start the economy through stimulus packages, tax rebates to encourage consumer spending, and/or tax cuts to spur growth.

These discussions are taking place in large measure because middle class anxiety has increased as the economy has contracted and the housing crisis worsened; the economy has now trumped Iraq as the most critical issue among voters. Studies commissioned by the NAW-led Tax Relief Coalition (TRC) have shown that as voters’ worries about their personal economic circumstances increase – many of them coping with stagnant wages, increased cost of living and rising personal debt – they are rejecting conventional pro-tax-cut arguments.

This political situation is a critical factor in the upcoming debate on taxes, especially for those on Capitol Hill who will be fighting for business-friendly tax policies. Class warfare arguments have been made calling for tax hikes on the rich and repeal of the `01 and `03 cuts for upper-income earners; in response, tax cut advocates have argued that the `01 and `03 cuts contributed to economic growth and job creation and were good for the country. While macro economic numbers support those arguments, the TRC research shows that voters simply don’t want to hear about the old tax cuts anymore. They want to know that their political leaders understand the new economic realities and have solutions to address today’s problems. But while voters do not want to hear about yesterday’s tax cuts, they also reject calls for tax increases. They believe government spends too much and wastes too much of what it spends, and instinctively know that raising taxes while the cost of living is on the rise is bad policy.

It is in this context that debate on some of the most critical tax policies of this decade will be conducted.

2007 re-cap:

One of the first actions of Congress in 2007 was the reestablishment of “pay-go” rules which require that any proposal that increases the deficit include in the legislation either entitlement spending cuts or tax increases – “offsets” – to “pay for” the legislation so that the result is “deficit-neutral.” In other words, under these bizarre rules, any proposed tax cut legislation would have to include tax increases of an identical dollar amount. And as a practical matter, pay-go is used only to block tax cuts, and never to constrain spending.

In addition to immediately imposing pay-go as an obstacle to tax cuts, the new Majority also quickly proposed a massive tax increase by calling for the repeal of the 2001 and 2003 tax cuts – including the reduced rates on income at all levels and on capital gains and dividends – which are currently scheduled to expire in 2010. They accomplished this by including in their required estimate of Federal revenue in 2011 the additional taxes that will be collected if the`01 and `03 rate cuts in fact expire. And removing any doubt that the expiration of the business-friendly tax provisions was their intent, they added a revenue provision to the Budget to provide for extension of some of the middle-class individual tax cuts that were also scheduled to expire (i.e., the child credit increase and marriage penalty relief).

Alternative Minimum Tax:

The AMT is an insidious tax originally enacted more than 35 years ago to reach 155 wealthy individuals who had successfully used tax deductions to avoid all taxation. But Congress failed to “index” the AMT to adjust for inflation, and the tax now reaches middle-class taxpayers who were never intended to be ensnared in the AMT parallel tax universe. Subsequent Congresses have failed to consider or defeated legislation that would have permanently corrected or repealed this flawed tax. Rather, each year they pass yet another AMT “patch” to protect additional taxpayers from its reach for one tax year. Failure to act in 2007 would have subjected an additional 20 million to AMT’s bite, and Congress very nearly did fail.

One of the first priorities announced by the new Democrat majority in 2007 was full repeal of AMT. And consistent with their pay-go rules, House Ways and Means Committee Chairman Charlie Rangel (D-NY) insisted that the measure be paid for. However, his Senate counterpart, Finance Chairman Max Baucus (D-MT) joined with his committee’s Ranking Republican Charles Grassley (R-IA) and called for AMT reform or repeal without offsets. Their reasoning – supported by NAW and the business coalition – was that it was fundamentally wrong to impose huge new tax increases on some taxpayers so that the government could repeal AMT but be “kept whole” and continue to collect revenue that everyone agrees it was never intended to receive.

The issue was debated without any actual legislation for virtually the entire Congress, with debate swirling around what tax increases the Chairman would propose to “pay for” either a one-year AMT patch (over $50 billion) or full repeal (about $875 billion over ten years). AMT reform/repeal became the focal point for discussion of virtually all other tax matters last year, including the extension of numerous tax provisions sought by business, middle-class tax reform, and what to do about the tax cuts expiring in 2010.

Chairman Rangel finally announced in October that he would introduce two separate AMT bills, a one-year “patch” and a measure calling for full repeal which he dubbed the ‘mother of all tax reforms.” Knowing that debate on that almost one trillion dollar tax increase would not occur until 2008, Congress finally turned its attention to protecting 23 million taxpayers from AMT’s bite in 2007.

The IRS had already begun warning Congress that if they did not enact an AMT patch quickly the agency would not be able to prepare tax forms in time and 2008 refunds would be delayed. Despite the warning, Congressional Democrats continued wrangling over how – and whether – to find tax increases to offset the AMT patch. Senate and House Republicans, relegated to the sidelines of the debate as the Minority party, called for action without offsets and criticized the Majority for their failure to act. Senate and House Democrats were each internally divided, and the two Houses were even further apart.

Finally, in early November, the House narrowly passed an $82 billion bill with a one-year AMT patch, extension of dozens of expiring tax breaks, and $82 billion in tax hikes primarily on private equity and hedge fund managers, real estate partnerships, and multi-national corporations. The bill was sent to the Senate for its consideration, beginning what is called a “ping-pong” process in which legislation is sent back and forth between the Houses until they can agree on exactly identical language. Meanwhile, the IRS continued to raise alarm bells about the delay.

The Senate refused to include tax increases in their legislation, and the House insisted that they would not and could not abandon “pay-go” and pass a bill without offsets. This back-and-forth continued right through the Thanksgiving recess and into December. At this point the IRS warned that tax filings and refunds would almost certainly be delayed.

Finally, on December 19th, with Christmas less than a week away, the House conceded the battle, abandoned “pay-go” and passed the Senate’s bill – a one-year AMT patch without offsetting tax increases.

And as they had repeatedly warned, the IRS announced that approximately 13.5 million taxpayers affected by the AMT will not even be able to begin filing their returns until around February 11th, as the agency scrambles to update its forms and systems.

LIFO (last-in, first-out) Repeal:

LIFO repeal was first considered in the Senate two years ago when then-Majority Leader Bill Frist (R-TN) proposed repeal to raise new tax revenue to offset, or “pay for,” a one-time tax rebate of $100 to some taxpayers in response to the very high gas prices at the time. Business response to the threatened repeal was swift and angry, and within four days the proposal was withdrawn.

Concerned that the issue was not permanently off the table, the D.C. business community organized an on-going campaign against repeal, forming a new, NAW-led coalition to coordinate the efforts. Coalition members met with dozens of Members of Congress and their staffs though 2006 and into 2007 to ensure that they understood the ramifications of repeal, especially that it would adversely impact smaller privately-held companies as well as the large publicly-held companies which were the intended targets of the original repeal proposals.

Although the Senate Finance Committee held hearings on the issue in 2006, no action was taken on the legislation. However, the threat to LIFO was raised again last year when House Ways and Means Committee Chairman Charlie Rangel (D-NY) included full repeal as one of the “offsets” – tax increases – in his “mother-of-all-tax-reforms” which he introduced last October. No action was taken on the “mother” bill, which is discussed in detail later in this report.

Death Tax:

Gradual repeal of the Estate (or “Death”) tax was included in the tax relief bill enacted in 2001, but under the arcane filibuster-proof reconciliation rules of the Congress, the repeal will last for only one year – 2010 – after which the tax recurs at the original 55% tax rate. Because all tax provisions enacted in Reconciliation bills expire within ten years, permanent repeal of the death tax will have to be considered outside of Reconciliation and therefore supporters will have to garner the 60 votes in the Senate necessary to overcome a filibuster.

The House of Representatives has passed death tax repeal legislation repeatedly since 2001, but unfortunately efforts to repeal and then to reform the tax both failed in the Senate, each time falling three votes short of the 60 necessary to cut off a filibuster.

While no floor action on death tax was expected under the new Majority in 2007 – and none occurred – it was brought back to life last November when the Senate Finance Committee held hearings on the issue in preparation for possible floor action in 2008. Senate Finance Chairman Max Baucus (D-MT) and Senate Republican Whip Jon Kyl (R-AZ) organized the hearings and are discussing next steps; however, there is no agreement yet on the terms of a compromise proposal. Moderate Democrats have proposed permanently freezing the death tax at its scheduled 2009 levels: a $3.5 million dollar exemption and 45% top rate. Senator Kyl’s last compromise proposal was for a $5 million per person/$10 million per couple exemption and a 35% top rate. Small business has argued strongly for the higher exemption while others prefer to see a lower rate. This debate will likely unfold in some form in 2008.

Ahead in 2008: The “mother-of-all-tax-reforms”:

The “mother-of-all-tax-reforms” bill which House Ways and Means Committee Chairman Charlie Rangel (D-NY) introduced last October calls for full repeal of the Alternative Minimum Tax (AMT), reduces the corporate tax rate to 30.5% percent, makes permanent the increase in small business expensing, and expands some “refundable” tax credits and other tax deductions for middle- and lower-income earners. But the cost to taxpayers of these reforms would be a $1.3 trillion tax hike to offset the proposed revenue loss. Moreover, the legislation assumes that the tax rate cuts enacted in 2001 and 2003 and set to expire in 2010 will NOT be extended and will be allowed to expire, resulting in additional $2.2 trillion in tax increases.

The House Ways and Means Committee Republicans immediately re-named this plan the “mother-of-all-tax-hikes” and called it the largest single tax increase ever contemplated in Congress: 3.5 Trillion Dollars. The tax increases proposed in this legislation are staggering.

The tax increases that would result from the expiration of the `01 and `03 tax cuts:

• Dividends would again be taxed as ordinary income rather than at 15%;
• The top capital gains would rise to 20% from 15%;
• The death tax rate would go from zero to 55% and the size of the exempt estate would fall back to $1million; and
• Marginal personal income tax rates would increase at all income levels with the top marginal rate going from 35% to 39.6%.

These taxes alone would severely impact the economy, but Chairman Rangel has proposed additional tax hikes that do another $1.3 trillion of damage:

• A surcharge of up to 4.6% on upper income earners – including the millions of businesses which file as individuals – bringing the top effective tax rate to 44%;
• Applying the surcharge to Adjusted Gross Income, not taxable income, negating the effect of deductions exemptions; and
• Complete and permanent repeal LIFO

NAW and the Tax Relief Coalition voiced strong opposition to Rangel’s “mother” bill, and TRC met with House and Senate Republican Leaders in December to discuss strategies for 2008. The Republican minority in the Senate has committed to filibuster this legislation should it reach the Senate floor, and the business community is united in its opposition, but we can expect a major fight on taxes this year and probably again in 2009.