How Washington Can Turn a Tax Increase into a Tax Cut by Leaping Off the Fiscal Cliff

By :: July 17th, 2012

In the strange alchemy of Washington, Congress can magically turn a tax increase into a tax cut.  And to make it happen, all it has to do is…nothing.     

Yesterday, Senator Patty Murray (D-WA) told an audience at the Brookings Institution that she would prefer to let the government tumble over the fiscal cliff at the end of the year rather than accept a deficit reduction plan built on spending cuts only. Murray—a senior Senate Democrat who speaks for her party’s leadership -- argued it would be better to allow the 2001/2003/2010 tax cuts to expire and let automatic spending increases kick in as scheduled rather than extend those tax cuts for the highest income households.     

No doubt, much of this is political posturing. With Republicans increasingly worried about the impact of those end-of-the year reductions in defense spending, and with the GOP’s presumptive presidential nominee Mitt Romney suffering through a rough patch, Democrats such as Murray may feel emboldened to raise the fiscal threat level to DEFCON 2.

But this is also about the arcana of budget baselines--where by waiting a few minutes on New Year’s Eve, Congress can entirely reframe the fiscal debate.

How? Let’s take a simple example. On Dec. 31, 2012 the top tax rate will be 35 percent. On Jan. 1, 2013, it will rise to 39.6 percent.

Say you are a politician who favors a top tax rate of, say, 37 percent. If Congress extends the 2012 rules and keeps the top rate at 35 percent, you would be raising taxes—a tough sell. But if Congress lets rates rise to 39.6 percent, your 37 percent rate looks like a tax cut.

The same thing happens to the dozens of mostly business tax subsidies that are expiring this year. Once they are extended for another year, any attempt to scale them back looks like a tax increase. But if they are allowed to expire, Congress can restore half of them and call it a tax cut. See, it is magic.

These steps would still increase the official Congressional Budget Office baseline deficit, since it already assumes the tax cuts expire. But the CBO deficit falls from $1 trillion in 2012 to about $585 billion in 2013. That gives you plenty of room to add back some tax cuts and still say you’ve reduced the deficit by hundreds of billions of dollars compared to 2012.

Democrats hope this strategy will change the conversation from the unproductive squabble over the Bush-era tax cuts to a serious talk about what a new revenue code should look like. It might insulate Democrats-- and more importantly Republicans-- from charges that they are raising taxes.

Besides, supporters of this strategy say, the whole fiscal cliff metaphor is all wrong. It is more of a fiscal slope, where spending cuts gradually bite and taxes slowly rise. In reality, they insist, any crisis would last only a month or two since the fear of recession would finally drive Congress to write a tax code that is fair, economically efficient, and sufficient to pay the government’s bills. Murray’s speech may have been part of an effort to adjust market expectations to reflect that hope.  

Still, this is a very risky game.

Inaction would wipe the 2001/2203/2010 tax cuts off the books, restore the Clinton-era estate tax, allow the Alternative Minimum Tax to hit 21 million taxpayers, and end the 2011 payroll tax cut. In fiscal 2013 alone, it would pull nearly $400 billion out of the economy. The psychological impact of a fiscal train-wreck on already-nervous businesses, consumers, and markets might multiply the risk. CBO figures these and other scheduled tax increases plus the automatic spending cuts would throw the U.S. back into recession.

Plus, it would be a tax administration nightmare. One example: Since the AMT fix has already expired, how would the tax be treated for Tax Year 2012 returns? Early filers would have to amend returns. It would be a mess.

For all that, deficit hawks and tax reformers see an opportunity to reframe the budget and tax debate—potentially a good thing. But it is a very dangerous way to get there.

 

4Comments

  1. Vivian Darkbloom  ::  4:26 pm on July 17th, 2012:

    “The same thing happens to the dozens of mostly business tax subsidies that are expiring this year. Once they are extended for another year, any attempt to scale them back looks like a tax increase. But if they are allowed to expire, Congress can restore half of them and call it a tax cut. See, it is magic.”

    That’s right. It’s a gimmick. But, let’s be honest, Howard. Isn’t this a varient of the baseline gimmick you used two posts ago to argue that the more tax rates are *reduced*, the harder it is to make cuts in tax expenditures? It is only harder because of the perception, not the reality. Tax rates, spending levels and adjustments to tax expenditures need to be evaluated and decided on in one contemporaneous budget package. All else is smoke and mirrors and jockeying for position.

    If your objective is higher tax rates, naturally you’ll argue that raising them first makes it “easier” tp cut expenditures. Conversely, cutting rates first makes it “harder” to eliminate expenditures. On the other hand, one could argue that by cutting expenditures first, this makes it easier to lower rates.

    Putting that earlier post together with this one makes your objective fairly clear: “Let’s raise rates”.

  2. AMTbuff  ::  2:57 pm on July 18th, 2012:

    The reality-based baseline is what taxpayers have actually been paying. That baseline can only change if higher tax rates are held in place for 16 months: a full calendar year plus 4 months to file tax returns.

    In the case of AMT relief, we are already 7 months into this period. By April 15, 2013 the tax liability baseline could be shifted by $8000 for affluent married couples. Will this happen? I’ll offer to 4 to 1 odds that Congress will act to prevent it.

    If Congress cannot stand pat a few months and let AMT relief expire for real, there is no chance that Congress will stand pat 16 months on the wider-scope expiration of tax rates.

  3. Vivian Darkbloom  ::  3:43 pm on July 18th, 2012:

    This gimmick reminds me of the “step transaction doctrine” in tax law. It has been summarized as follows:

    “;;;interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus linking together all interdependent steps with legal or business significance, rather than taking them in isolation, federal tax liability may be based on a realistic view of the entire transaction”.

    Clark v. Commissioner, 489 U.S. 726, 738 (1989).

    But, it acually dates back to Gregory v. Helvering in 1935. In other words, it is nearly as old as the tax code.

    In other words, substance over form.

    Not surprisingly, some people think it still works, but honest and knowledgeable tax lawyers and professionals try to avoid running afoul of it. Too bad politicians (and tax policy foundations) can’t be sued for abusing the same concept. But, you’re right, the amount of time between the steps helps your case.

  4. Michael Bindner  ::  7:57 pm on July 19th, 2012:

    The TPC’s own analysis shows that falling off the fiscal cliff only impacts the lowest three quintiles by $5, $10 and $25 per week – which is not unaffordable compared with the impact on the top 0.1%. The prospect of this actually happening may just make GOP donors realize that its time to shut Grover Norquist up and make their best deal now. One look at the Electoral College numbers in Real Clear Politics should convince them to make their best deal now, rather than waiting until Obama gets a second term and has coat tails to win back the House. From what I saw Wednesday nite, Eric Cantor has a serious competitor. If he succeeds, expect many more like him.