SPECIAL REPORT

As Lawmakers Return to the Hill, White House and Congress Settle in for Battle Over Budget Numbers

Tuesday, April 24, 2001

Deloitte & Touche OnLine

Debate over this year's tax cut bill in the 107th Congress continues to be a numbers game. President Bush has for several months pursued a $1.6 trillion, 10-year tax relief package. The core of this package – $1.4 trillion – is rate cuts, marriage penalty relief, estate tax repeal, and increased child credits.

Just before Easter, however, the Senate sent Bush a clear signal that he will not reach his target. On April 6, the Senate voted for a budget resolution with $1.2 trillion in tax cuts, shaving about 25 percent off the president's proposal. The Senate resolution – which includes $85 billion in immediate tax cuts as an economic stimulus – also has more spending for education, agriculture, defense, and prescription drug benefits.

For its part, the House on March 28 approved a budget resolution that would fully fund the president's proposed $1.6 trillion tax cut. The House had already approved $958 billion in income tax rate cuts, $400 billion in marriage penalty relief and child tax credit expansion, and $185.5 billion in estate tax relief.

Setting the Stage – With the House and Senate budget resolutions in place, the stage is now set for both chambers to reconcile their positions – taking into account all of the president's priorities. That process will begin when lawmakers return from their spring recess April 23.

One implication of these recent developments is that some of the more than $1.5 trillion in tax cuts the House already has passed will likely not survive. To fit under a lower cost ceiling, some of these will have to be scaled back. For example, the estate tax may be reduced, not repealed, while marginal rates for some upper-bracket taxpayers may be cut, but not as much as the president wanted.

Budget Constraints

The Bush administration on April 9 released a detailed explanation of its fiscal year 2002 budget. As we expected, there are no major changes from the preliminary documents the administration presented in February. Most significantly, there were no tax increase proposals. None of the Clinton administration's "loophole closers" or anti-abuse proposals were repeated. 

As now officially proposed, the 10-year, $1.6 trillion tax cut package focuses primarily on individuals, not corporations. Highlights include repeal of the estate tax, an extension of the research and development (R&D) tax credit, and reductions in the individual income tax rates. The administration's budget also includes proposals to –

• permanently extend favorable tax treatment of the costs of cleaning up contamination at abandoned waste sites (brownfields);

• modify tax credits for nuclear decommissioning costs;

• provide refundable tax credits for the purchase of health insurance;

• provide an above-the-line deduction for long-term care insurance premiums;

• allow up to $500 in unused benefits in a health flexible spending arrangement to be carried forward to the next year;

• permanently extend and expand medical savings accounts (MSAs);

• exclude from income the value of employer-provided computers and software; and

• exclude 50 percent of gains from the sale of property for conservation purposes.

The Bush budget also provides for one-year extensions of these expiring provisions:

• Work Opportunity Tax Credit;

• Welfare-to-Work Tax Credit;

• Exclusion for employer-provided educational assistance;

• Subpart F exception for certain active financing income;

• Suspension of net income limitation on percentage depletion from marginal oil and gas wells;

• Authority to issue qualified zone academy bonds for public school costs; and

• Minimum tax relief for nonrefundable personal tax credits (other than the child credit).

Budget Busters – The 10-year cost of these provisions – just over $108 billion – when combined with the cost of the president's core proposals, could prove to be a budget buster in both the House and the Senate budget resolutions. The $1.2 trillion set aside for tax relief in the Senate resolution would be inadequate to cover these proposals. The $1.6 trillion in the House budget resolution theoretically would pay for them – but House lawmakers already have allocated over $1.5 trillion to other priorities.

Compounding this problem is the fact that many House Ways and Means Committee members have not yet addressed some of their own tax cut priorities. House members on both sides of the aisle have said, for instance, that they want to pass legislation to expand and enhance pensions. This and other initiatives in the wings would quickly send total House tax cuts crashing through a $1.6 trillion ceiling.

Bad News for Business? – Corporate tax cuts are not addressed in the Bush plan, with the exception of a permanent extension of the R&D tax credit. In Congress, individual income tax, estate tax, and even small business tax relief will take precedence over corporate tax relief.

In effect, the president's core individual tax cuts threaten to crowd out even the most popular and relatively modest business tax breaks, such as making the R&D tax credit permanent. Other broader business breaks have little chance of passage this year or even next.

This outlook would change only if dramatic new favorable surplus projections were to arise. For now, business will, at best, have to settle for less costly pet projects of influential members. In the Senate Finance Committee, members may be able to add modest priority measures as the committee seeks broader support for its final bill.

In effect, the president's core individual tax cuts threaten to crowd out even the most popular and relatively modest business tax breaks, such as making the R&D tax credit permanent. Other broader business breaks have little chance of passage this year or even next.

A corporate wish list of other priorities that will likely have to wait for another day – if not another term – includes depreciation, corporate alternative minimum tax (AMT) relief, international tax relief, the Internet tax moratorium, and other industry-specific issues.

Taxwriters Hesitate, But Leave Doors Open

There are many other business measures that individual lawmakers will likely push in the 107th Congress. House Ways and Means Chairman Bill Thomas, R-Calif., has indicated that there will be a tax bill dealing with corporate issues at some point this year. Senate Finance Chairman Charles Grassley, R-Iowa, has also shown some appetite for corporate issues.

Likewise, there is similar support among those in the Republican leadership. Majority Leader Trent Lott, R-Miss., for example, has said he wants a cut in the capital gains tax as an economic stimulus.

Subpart F, International Proposals – Lawmakers also are looking into a number of international tax proposals. In remarks at the Georgetown University Law Center's Institute on International Taxation April 19, Senate Finance Committee Majority Tax Counsel Edgar McClellan said that the committee is considering a permanent extension of the subpart F exception for active financing income. (A bill to make the active financing exception permanent was introduced in the Senate April 2 by Finance Committee member Orrin Hatch, R-Utah.) Also up for discussion are proposals to simplify subpart F and the foreign tax credit rules, McClellan said.

For his part, Grassley, addressing the Tax Council on April 23, offered this assessment of whether there will be room for any international tax provisions this year: "If we get a $1.6 trillion tax package, yes. If we get a $1.4 trillion package, maybe. If it's only $1.2 trillion, no." The active financing exception likely will be addressed in an extenders bill, he indicated.

On the issue of foreign sales corporations, "it appears the [World Trade Organization] won't issue a final decision until late summer," Grassley said. "We are following the situation closely and will be prepared to respond if necessary, but I don't want to do anything more than just the minimum to satisfy the WTO."

Corporate AMT Relief – The issue of giving corporations relief from AMT liability is a "number buster," according to Grassley. "It's not on the agenda because before that – as illegitimate as AMT is in the first place – we must do something on individual AMT. I can't lead you to hope for anything else right now. Even at $1.6 trillion, we'll have a hard time fitting individual AMT relief into the mix."

Second String – Senate Majority Whip Don Nickles, R-Okla., said he would like to see the Senate address other areas of business tax relief, but acknowledged that business priorities will not be in the first group of tax reductions this year and that even if a second tax bill is passed, "it will be a challenge to get them at any time soon."

It is possible that the Ways and Means Committee may attempt to move other tax proposals such as extension of the R&D credit and pension legislation before the budget agreement is concluded so that members can have the opportunity to vote for these items before the constraints of the budget resolution take effect.

Appropriations bills will be produced from mid-spring into the fall, and by law all should receive a presidential signature by October 1, the beginning of the next fiscal year. Because this is the first time in more than 50 years that a GOP White House will collaborate with a Republican-controlled Congress on a federal budget, the appropriations bills will likely reflect many of the president's priorities.

Tax Shelters – Beyond tax relief, the prospect of corporate tax shelter legislation also looms this session. "The Finance Committee will be dealing with many issues that help business, and I am committed to making the tax code fairer for individuals and businesses alike. But I want to be frank with you on tax shelters. We have continued to work on this, so we can more effectively address abuses without hurting legitimate transactions," Grassley told the Tax Council. (McClellan told the Georgetown University Law Center that the Finance Committee is working on draft tax shelter legislation.)

On the regulatory front, Treasury's Eric Solomon has indicated that the Treasury Department's business plan, in response to practitioner comments, may include changes to the corporate tax shelter rules.

Bipartisanship a Necessity

Calls for bipartisanship are more than just rhetoric in an evenly divided Senate, where the votes of moderates can hang up any bill. The president needs to maintain an environment with the potential for real cooperation. To alienate the Democratic half of the chamber and several moderate Republicans by forcing through a full $1.6 trillion tax bill that a majority does not want would jeopardize prospects for cooperation on other legislation in the future.

Bush has been selling his tax cut plan as a stimulus for a struggling economy. Yet that very strategy may have increased the anxiety of fiscally conservative members that the projected surplus will not materialize.

Ironically, the president may be creating some of his own problems. He has been selling his tax cut plan as a stimulus for a struggling economy. Yet that very strategy may have increased the anxiety of fiscally conservative members that the projected surplus will not materialize. Indeed, published press reports indicate lower-than-
expected tax withholding totals as well as large corporate tax refunds, both of which are putting downward pressure on the surplus. If these trends continue, surpluses may fall short of projections. Should that happen, the July surplus increase lawmakers are hoping would allow for more tax cuts may not materialize. In effect, the president may be making some lawmakers hesitant to support his tax plan until they see more evidence of future surpluses.

By extension, the prospect of dwindling surpluses also may be raising concerns about whether another tax bill will even be possible next year. That could pressure members to pursue their particular interests this year – when a tax bill is sure to pass – possibly at the cost of not passing some parts of the president's core cuts.

Another challenge facing the president is the need to move tax cuts along before those constituencies adversely affected by proposed spending cuts get bad news from the appropriations process. There is a real tax and spending tradeoff. Democrats will want to speed up the appropriations process and slow down the tax cut process so they have more concrete examples of the spending costs associated with the tax bill.

Legislation That's Still Alive

To date, only the House actually has approved tax legislation. The Senate Finance Committee is expected to draft legislation in the coming weeks. Grassley said April 23 that he expects the Senate to wrap up its version of a tax bill by Memorial Day. (Major tax initiatives in the 107th Congress and their prospects for passage are discussed in some detail below. For a quick overview, see the appendix at the end of this article.)

Rate Cut – On March 8, the House voted 230-198 to approve a rate cut modeled largely on the president's proposal, which would reduce the top tax rate to 33 percent. Ten Democrats joined a unanimous Republican caucus to approve the measure. In recent weeks, President Bush has pushed for a retroactive tax cut to stimulate the economy, however the income tax rate cuts would have their greatest impact in the out years. Because of phase-in provisions, the House-passed bill would withhold 62 percent of the tax relief until the years 2007-2011.

Estate Tax Reform – On April 4, the House voted 274-154 – with 58 Democrats joining 215 Republicans – to pass a 10-year, $185.5 billion bill to repeal the estate tax. Beginning in 2003, the estate, gift, and generation-skipping transfer tax rates would be reduced each year until they are fully repealed in 2011. In 2003, the unified credit would be replaced with a unified exemption; the 5 percent surtax (which phases out the benefit of the graduated rates) and the rates in excess of 53 percent, would be repealed.

Following repeal, an heir's basis in inherited assets would equal the donor's basis in those assets at the time of death. A decedent's estate would, however, be allowed to increase the basis of assets transferred by up to a total of $1.3 million. An additional $3 million could increase the basis of property transferred to a surviving spouse. The outlook for a full repeal of the estate tax in the Senate is uncertain, although some sort of estate tax relief is likely.

Marriage Penalty/Child Credit – On March 29, the House voted 282-144 to approve legislation to cut income taxes for married couples by widening the 15 percent income tax bracket, increasing the standard deduction for married couples, and doubling the $500 child tax credit over five years. Sixty-four Democrats voted for the bill. The House rejected the president's request to increase the income eligibility limits on the child tax credit.

Minimum Wage – The Senate reportedly could take up as early as next week legislation providing for a $1.00 an hour increase in the minimum wage.  To help offset the potential cost to small business resulting from this increase, the legislation will likely include a package of tax provisions targeted to small business.  Among those proposals likely to be included are an acceleration of full deductibility of health insurance costs for the self-employed; an increase in the section 179 equipment expensing limitation; an increased deduction for business meals; and a provision allowing certain small businesses to use the cash method of accounting.  

Endangered Legislation

Permanent R&D Tax Credit – The proposed permanent extension of the 20 percent R&D tax credit – set to expire in 2004 – is the only business initiative in the president's budget. Many on Capitol Hill, however, are quietly suggesting that next year will be soon enough to address this issue.

"The climate now is focused on individual issues, so it's no small feat that a permanent R&D credit made it into the Bush tax proposal," according to Grassley. "If the whole tax package ends up being $1.2 trillion, you may not have room for a permanent R&D credit, but rather get some temporary extension. But I'd rather see it made permanent."

Pensions – House Ways and Means Committee members Rob Portman, R-Ohio, and Ben Cardin, D-Md., introduced the Comprehensive Retirement Security and Pension Reform Act (H.R. 10), a popular bill that would cost $52 billion over 10 years. Although pension reform is not addressed in the Bush proposal, the Portman-Cardin measure has the support of House Majority Leader Dick Armey, R-Texas, who, with other senior members of the GOP leadership, has called for the package to be added to Bush's tax plan. Ways and Means Chairman Bill Thomas, R-Calif., indicated March 15 that pension reform could be considered as part of a tax cut package.

The Portman-Cardin bill would increase the annual contribution limits for individual retirement accounts (IRAs) to $5,000 (from $2,000) and increase annual contribution limits on employer-sponsored defined contribution plans, such as 401(k) arrangements, to $15,000 (from $10,500) by 2005. Other provisions in the bill would hike the employer's deduction for contributions to pension plans; lower vesting requirements for employer matching contributions to three years (from five years); increase the limits on all employee contributions by $5,000 for workers age 50 and older; create new "Roth" 401(k) and 403(b) savings plans; and enhance pension portability by allowing people who change jobs to roll over their retirement savings between different types of plans. The measure also would allow employee stock ownership plan (ESOP) dividends to be retained in the plan without the loss of the dividend deduction.

Grassley and Finance Committee ranking Democrat Max Baucus of Montana on April 6 introduced the Retirement Savings and Security Act of 2001, which is similar to the House bill and includes tax credits for contributions to retirement plans. The major difference from the House bill is a package of tax credits for low-income workers and small businesses.

Grassley has said that budget constraints could preclude the Senate from considering his pension reform bill this year.

Appendix: Tax Legislation At A Glance

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