Mountains of Policy Under Pressure to Change
The current environment
Excerpted from The 2012 Essential Tax and Wealth Planning Guide
Late last year, Congress approved and President Obama signed legislation that extended the more favorable Bush-era tax rates for individuals — which were about to expire — through 2012. It also put into place a temporary estate tax regime for the same period. With the prospect of yet another scheduled expiration now just over one year away, individuals once again face the same uncertainty over future tax rates that existed through 2009 and 2010. If Congress fails to adopt a more permanent tax structure before the end of 2012, the income tax rates and the estate and gift tax would revert to pre-2001 law. Such an event would usher in across-the-board tax increases for all taxpayers. Although there is nearly unanimous support for preventing tax increases on low- and middle-income taxpayers, the fight over taxation of higher-income individuals continues.
Two additional uncertainties have been introduced that will make tax planning more challenging. First, as part of the 2010 health care reform legislation, Congress enacted increases in the Medicare Hospital Insurance tax for high-income individuals, which are scheduled to take effect in 2013. These increases would impose additional nondeductible taxes of 0.9 percent on wages and 3.8 percent on investment income. These scheduled new taxes likely will exacerbate the conflict over taxation of higher-income individuals as 2013 approaches.
Second, in the context of budget reform and deficit reduction, congressional leaders and administration officials have begun identifying tax reform as a priority. To date, these discussions have focused on the broad concepts such as dramatic rate reductions accompanied by repeal of various tax benefits. As of September 2011, proponents of reform largely had avoided defining the specifics of what taxpayers would be asked to sacrifice in any reform. The extent to which tax reform becomes an actionable initiative will depend on many factors including the reaction of taxpayers to specific proposals.
With the political parties divided over the taxation of higher-income individuals and their approaches to tax reform, taxpayers should not expect uncertainty over the future of taxes to resolve itself quickly or easily.
Mountains of policy under pressure to change
Looking back, from 1963 through 2007 on the eve of the great recession, the federal government’s total non-interest spending grew by only 0.3 percent of gross domestic product (GDP). Washington’s non-interest spending accounted for 17.6 percent of the economy in 1962 and rose to 17.9 percent in 2007. During this same period, total income tax receipts declined and wage taxes increased. The net result was that federal receipts rose from 17.6 percent of GDP to 18.5 percent. Policy changes over those nearly 50 years, however, dramatically altered the mix of federal spending.
In 1962, more than half (almost 53 percent) of the federal budget was spent on defense-related activities while mandatory (entitlement) spending accounted for 28 percent of the budget and domestic discretionary spending accounted for under 20 percent. In 2008, the nondefense discretionary share of the budget was virtually unchanged at just under 20 percent; but mandatory spending for Social Security, Medicare, and other entitlements had replaced defense spending as the central activity of government, accounting for over 58 percent of spending. Defense spending shrunk to 21 percent of spending.
This large shift of government spending from defense to the provision of retirement and health benefits reflects changes that have created an unsustainable long-term fiscal outlook. As the baby boom generation retires, current Social Security and Medicare commitments may deplete the resources of the federal government. By the middle of the next decade, taxes under current policy could not cover the cost of interest, Medicare, and Social Security even if every other government program were terminated.
Addressing the challenges
In recent months, Congress and the Obama Administration have begun to address these challenges by reducing non-entitlement spending. But, over time, setting the nation’s fiscal house in order likely will require dramatic entitlement spending and benefit reductions as well as tax increases. Exactly when these changes will occur or what form they will take is unknown; however, the uncertainty may be much less than it appears to be at the outset.
Significant spending cuts in entitlements are highly likely – The sheer size of our future commitments to aging baby boomers will require entitlement reform. The future increase in federal deficits as a share of the economy projected by the Congressional Budget Office (CBO) is due entirely to growth in entitlements and interest costs. Entitlement spending — principally spending on Social Security and Medicare — will have to be reduced. Such cuts could have material impact on your retirement planning. Various approaches to reducing Social Security spending include increasing the retirement age, reducing the inflation adjustment applied to benefits, means-testing the benefit, and partially privatizing the system. Similar approaches could be taken with Medicare.
When Congress has considered direct benefit reductions in the past, it protected retirees and those near retirement by applying changes to individuals below a set age such as 55 years. This approach may not work well in the current environment given the growing urgency of our debt and deficit situation and the fact that policy changes to constrain costs would have little impact for a decade or more. To put this issue in perspective, the Census Bureau estimated that in 2009 there were 39.6 million Americans age 65 and older, of whom 5.6 million were over 85. The next generation of retirees, those ages 55 through 64, was comprised of 34.8 million people. Some types of entitlement reform such as means testing or full taxation of benefits could be applied to higher-income or higher-net-worth individuals as part of a future reform with more limited grandfather protections.
Some tax increases also are likely – As reforms and benefit reductions occur in entitlements, this question will inevitably arise: How much more should we reduce Medicare and Social Security benefits in order to avoid any tax increase? If you believe that the answer to such a question brings tax increases with it, you may want to assume that high-income taxpayers will experience tax increases. The defining element of the ongoing budget debate will be a hard-fought agreement on how much of the solution will come from the spending side and how much from the tax side.
All taxpayers may have to contribute to solving our fiscal problems – Philosophically, many will argue that the benefits of the deficit spending that has occurred in the last decade, and of rapidly growing entitlement spending, accrue to all citizens, not just those in the top income tax brackets. They will conclude that middle-income taxpayers should make some contribution toward balancing the budget.
Lawmakers have struggled intensely with reaching agreements in a timely manner during the 112th Congress, and that pattern will likely continue as they focus on expiring tax cuts. As a result, the tax landscape for 2013 may not become certain until days before the end of 2012. In a lame duck session that takes place after the November 2012 election, but before a new Congress and the next presidential administration take office, the path of least resistance for the current Congress and the White House could be a second temporary extension of tax cuts. A one- or two-year extension would create the space for a tax reform debate that would resolve the issues on a permanent basis. If the economy continues to be slow in recovery, an extension could support continued recovery. The winners of the 2012 election could welcome a short-term patch as providing them with the chance to shape policy. The losers might correspondingly welcome it as placing the full burden of tax policy — including its economic and deficit effects — on the winners.
This pattern of legislating does not afford individuals the luxury of waiting to plan tax decisions until Congress reaches an accord. You would do well to consider tax planning decisions far before the end of 2012 based on whether you expect the current rates to continue or change beginning in 2013.
When the 113th Congress convenes in January 2013, action on a long-term tax reform plan is likely to become a central focus in Washington. The debate will be influenced by the agreements reached at the end of the 112th Congress over the debt ceiling, spending, fiscal year appropriations, the expiring tax cuts, and the package of annual tax extenders. The tax reform path that Congress chooses also will hinge on the gains and losses each party suffers in the 2012 elections. If supported by presidential leadership, the next Congress will likely move tax reform forward with a deadline for final action in 2013 or 2014.
The risk remains, however, that we could see alternative scenarios resulting in an expiration of some or all of the Bush tax cuts if the 2012 lame duck session fails to produce a similar compromise to that reached at the end of 2010.
The tax reform debate
Looking beyond 2012, there are three broad possible scenarios under which the 113th Congress could move forward to reach a long-term solution to individual income tax and tax reform issues.
Lower rates, fewer tax expenditures, spending-driven deficit reform – Congressional Republicans have advocated comprehensive tax reform as a necessary component of deficit reduction. They believe that tax reform that does not increase tax burdens can improve U.S. competitiveness and remove barriers to economic efficiency and growth by lowering rates and eliminating tax preferences that distort economic decision making.
Tax reform accompanied by tax increases that help reduce deficits – Congressional Democrats and various bipartisan deficit-reduction commissions have advocated a similar tax reform as part of their approach to deficit reduction. But they have also suggested that revenue provisions such as a value-added tax or an increase in the gasoline tax are necessary to reduce the deficit.
An important assumption in these tax reform proposals has been that the appropriate starting point in terms of total revenue, and, implicitly, the distribution of tax burdens, is a baseline that assumes expiration of the Bush tax cuts for individuals earning more than $200,000 and couples earning more than $250,000.
A lingering standoff over the size of government and tax policy – A comprehensive deficit reduction strategy may be a prerequisite to comprehensive tax reform. To date, Congress has pursued an incremental approach to shrinking the deficit by approving a small reduction as part of the continuing resolution it approved in April, followed by a $917 billion reduction and a mechanism to force an additional $1.2 to $1.5 trillion in cuts as part of the agreement it reached with the White House to increase the federal debt ceiling. If the next Congress adopts a similar approach, continued pressure to cut spending and a standoff over entitlements could sideline tax reform efforts.
Planning in uncertain times
The prospect that Congress could act on comprehensive tax reform in 2013 or 2014 raises new tax planning concerns. For more than a decade, high-income taxpayers have planned with an assumption that eventually taxes and tax rates would increase. You reasonably may continue to hold that view, particularly with respect to rates on capital gains and qualified dividend income. The tax reform discussion creates two additional possibilities: rates may come down while total burdens increase, or rates may come down without total burdens changing significantly.
These possibilities are far enough away in time that they may not heavily influence your 2011 and 2012 planning; but to the extent that you are engaged in multiyear planning that includes 2014 or 2015, you will want to develop your own long-term outlook on taxes and tax rates.
If you believe that tax rates will decline as a result of tax reform, opportunities to defer income or to invest in qualified retirement plans will look that much more attractive. If you believe that capital gains rates will go up dramatically as a result of reform, you will want to consider appropriate strategies as reform moves closer in time.
Whatever you conclude the future will hold for taxes, a long-term commitment to adhering to a thoughtful tax planning process can help mitigate risks as you approach what could be a dramatically different tax landscape in future years. To that end, you should:
Continue to plan; work with what you know – In the face of such uncertainty, it is tempting to do nothing on the grounds that it is too hard to know what to do. Of course, in tax and wealth planning, a decision to do nothing is still a decision and could be a bad one. We believe significant tax changes will occur, although those changes may not occur before 2013 or 2014 and may phase in over time. Until change comes, taxpayers may find that disciplined planning under present law could produce real benefits. This is particularly true given the seemingly certain outlook for tax rates in 2011 and 2012 and the reasonable possibility that the 2001 and 2003 tax cuts will be extended once more for 2013. Many of the benefits under existing law are likely to continue. For example, there is no basis to believe that Congress and the administration will consider taxing existing retirement savings, although they may simplify and consolidate available saving vehicles prospectively. Similarly, they are unlikely to make interest on existing mortgages nondeductible.
Adopt a view of the future and plan accordingly – We are confronting two competing visions of future taxes. Some would restore the top tax rates that existed before 2001, and others would reform the tax system so that top rates could be set in the 25 to 28 percent range. Similar variations in views exist with respect to the Medicare tax scheduled to be added in 2013. As a result, you could reasonably assume a tax rate on ordinary income for 2014 and beyond that ranges anywhere from 25 percent to effectively almost 44 percent. If you believe strongly in the potential for tax reform, planning to appropriately defer tax for several years will be of interest to you. Conversely, if you believe tax rates are bound to increase, then income acceleration will become attractive to consider in late 2012 or in 2013.
Be wary of quick answers and simple advice – Tax legislation never concludes in the manner in which it starts. The U.S. and global economies and our governmental processes are highly complex, as are the structures, instruments, and businesses to which a tax law must apply. Even simple tax proposals evolve and change during the legislative process. Before taking action in response to a potential change, taxpayers should completely analyze a proposed transaction and alternative outcomes. For example, while selling an asset to avoid a higher capital gains tax in the future may make sense in some cases, it may be costly in others.
A planning decision will depend on the amount of gain to be recognized relative to the asset’s fair market value, the cost of the initial and anticipated subsequent transactions associated with the plan, the expected return on the asset, and the expected increase in tax rates. There is no simple, quick, or uniform answer.
Watch for opportunities and know your risks – The mere discussion of dramatic tax changes and new taxes can influence markets. Continuing uncertainty over the long-term outlook for the federal budget influences financial markets and the value of the dollar. As an investor, you should work to be informed about significant tax and nontax reforms and position your portfolio in a manner consistent with your conclusions about how changes will affect investment opportunities.
Although the potentially dramatic level of the changes we see ahead creates unparalleled uncertainty for individual tax and wealth planning, it also can create opportunity for those who address the uncertainty head on.
For more details on tax and wealth planning in our current environment, download The 2012 Essential Tax and Wealth Planning Guide.
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