POTENTIAL TAX IMPLICATIONS OF DEFICIT REDUCTION

The Budget Control Act of 2011

The final act of the debt ceiling melodrama in Washington, the Budget Control Act of 2011 (P.L. 112-25) (“BCA”) seeks to increase the debt ceiling in two separate phases.  Phase one is an automatic $400 billion increase, to be followed by an additional $500 billion so long as Congress doesn’t pass a disapproval resolution.  Phase one is coupled with a mandatory $917 billion in deficit reduction for fiscal years 2012 – 2021.

Phase two involves a second increase to the debt ceiling of $1.5 trillion and provides a mandate for creation of a Congressional Joint Select Committee on Deficit Reduction (“JSCDR”).  The JSCDR is to consist of twelve members of Congress, six from each house, with membership to be divided equally among republicans and democrats.  The JSCDR must identify at least $1.5 trillion in deficit reduction for fiscal years 2012-2021.  If the JSCDR fails to achieve its mandate, then the debt ceiling will automatically increase by $1.2 trillion, and a corresponding $1.2 trillion in deficit reduction that will occur pursuant to pre-selected spending cuts to begin in 2013.

Tax Increases vs. Spending Cuts

The emergent issue faced by the JSCDR appears to be whether it will accomplish its deficit reduction goal through spending cuts or tax increases.  However, the magnitude of reduction called for by the BCA makes use of spending cuts alone impractical, so in all likelihood the measures adopted by the JSCDR will include some of both.  So, what does this all mean?

Well for one thing, the now infamous Bush tax cuts will be reappearing in headlines.  The primary issue here will be whether allowing these tax cuts to expire should be considered a tax increase, because in truth, the tax code would only be reverting to its codified form.  There will also be talk of closing “loopholes” in the tax code, eradicating LIFO accounting for business inventories, and probably even some more “radical” tax reform measures such as a federal sales tax.

The imposition of a value-added tax (“VAT”) has been gaining some traction politically.  A VAT works something like a sales tax, except that it shifts the source of taxation from retailers to manufacturers, and potentially, service providers.  From a very broad perspective, then, each “producer” in our economy bears the burden of taxation based upon its “value added” to a product or service that is eventually sold to consumers.

A more simplistic alternative that has been proposed is the reduction of corporate income tax rates.  While at first this may not sound like a tax increase, the proponents of this approach argue that reducing corporate taxes will allow corporations to hire additional employees, thereby expanding the overall income tax base and raising tax revenues. Those against this option argue (perhaps rightfully so) that corporations will glutton themselves on additional profits rather than hire more employees, and continue to increase reliance on automated manufacturing processes and foreign outsourced labor.

You may be wondering what your President has to say about this.  The White House has not been bashful about taking a stance in favor of tax increases to solve the deficit issue.  Specifically, the White House as promoted the following measures:

·       Terminate LIFO accounting for business inventories, raising an estimated $60-70 billion in tax revenues over 10 years.

·       Place a cap on itemized deductions for individuals with adjusted gross income (AGI) over $200,000 and families with AGI over $250,000, raising an estimated $300 billion over 10 years.

·       Levy ordinary income tax rates on carried interest, raising an estimated $20 billion over 10 years.

·       Repeal oil and gas company breaks, such as the allowance for claiming a deduction under the percentage depletion method.

·       Change the required MACRS useful life for depreciation of corporate jets from five to seven years.

Conclusion

Realistically, if the United States plans to realize nearly $2 trillion in deficit reduction over the next ten years then the American taxpayer is going to wind up paying at least part of the tab.  The only real questions are how, when, and how much.  These issues will be hotly debated over the coming months, and are of great importance to the global economy.  In these tumultuous times, citizens should consult their tax advisor on a regular basis to ensure that they are prepared for whatever the tax outcomes of this deficit reduction “crisis” should be.