The tax debate has been on the backburner as bipartisan infrastructure negotiations have sidelined any tax increases. But that will soon change when Democrats move towards budget reconciliation.
President Biden and Democratic leadership in Congress are getting ready to start the budget reconciliation process in an attempt to pass as much of the American Jobs Plan (AJP) and American Families Plan (AFP) as possible. Along with the $4+ trillion of spending from the AJP and AFP, Biden included $3+ trillion in tax increases. These tax increases were further detailed in the Treasury green book released last month. Biden and progressives are looking to emphasize the popularity of tax increases on corporations and the wealthy. Recent events like progress from the G7 on international tax negotiations and the ProPublica release of confidential tax records of the richest Americans also are spurring headlines on the taxation of corporations and the wealthy. But plenty of Democrats in Congress did not get the memo from Biden to lean-in on tax increases. Biden’s tax proposals have received a muted reception among several tax writers, creating uncertainty about what Democrats will actually put forward and what can get unanimous support in the Senate and near unanimous support in the House.
Democratic tax writers in the House and Senate have largely held off on putting forward proposed tax hikes. But that will change as Senate Finance Committee Chair Ron Wyden (D-OR) has indicated he will soon release some of his own tax legislation. However, there still needs to be an agreement by Democrats in Congress on how much revenue actually needs to be raised. This will depend on the fate of bipartisan infrastructure talks, the topline spending number for reconciliation, and any appetite for deficit spending. Then there’s the ultimate question of what can get the requisite votes. Democrats have strategically held off in releasing legislation to ensure there is less time to foment opposition. But there’s already opposition occurring from Biden’s proposals. It will take a full-on effort from Democratic leadership and committee heads to keep the rank-and-file together when it comes to voting for tax hikes.
Bipartisan Infrastructure Talks: Read My Lips
The last major bipartisan tax increase was President George H.W. Bush’s deficit reduction package in 1990. That’s when the famous “Read my lips: No new taxes” refrain backfired on Bush. Political polarization has increased quite a bit since then.
The biggest sticking point of all in bipartisan infrastructure negotiations continues to be the pay-fors. The House Problem Solvers Caucus last week proposed $762 billion in new spending over eight years. That means $762 billion in offsets. It actually means more since the current revenue from the gas tax does not cover the current baseline of Highway Trust Fund spending. There’s a projected $140 billion funding shortfall for surface transportation spending over eight years at current baseline spending. So we are talking about $900 billion if (and that’s a big if) both sides agree to a deal of $762 billion in new spending. The Problem Solvers Caucus did not release any proposed pay-fors.
Over in the Senate, 10 members (five Democrats and five Republicans) last week reached a tentative deal for $579 billion of new spending, either over five or eight years. While the full details were not released, it would be fully paid for and include no tax hikes.
When Republicans are swearing off new taxes and Democrats are swearing off new user fees (like an increase in the gas tax or creation of a vehicle miles traveled (VMT) fee), finding a path to raising $600-$900 billion is challenging.
Potential bipartisan revenue options could include indexing the gas tax to inflation. But the revenue raised there is estimated to be just $30–35 billion over 10 years. The Biden administration has already come out in opposition of it. There’s bipartisan interest in increasing IRS funding for better enforcement to close the tax gap, although there’s a difference in how to go about it. There are also probably some budget gimmicks that could be employed. Then there’s the question if there’s a willingness for just plain old deficit spending. But these are big problems for a group of rank-and-file members of Congress to solve and sell to party leaders and the broader Congress. They realistically have little time to solve and sell it.
The Reconciliation Tax Agenda
Democrats will raise taxes in a budget reconciliation bill. The outstanding question for tax writers is how much revenue do they have to raise. If Democrats could get the votes to deficit spend, calling the AJP and AFP “economic investments” that will partially pay for themselves over the long term, they would do just that. There may be other avenues for raising revenues, like increasing IRS funding and drug pricing reforms. They could also expand the budget window for taxes beyond the spending budget window (e.g. 15 years of taxes vs. 10 years of spending) so that the taxes they do propose appear to raise more money.
Then there’s coming to a topline on the spending, a number that we expect will be pared back by certain moderate Democrats. The outcome of bipartisan negotiations will also play a major role in the Democratic tax agenda. If a bipartisan deal can be made that takes about $1 trillion off the table in new spending (whether it be from a bipartisan infrastructure bill plus a bipartisan water infrastructure bill and a bipartisan China competitiveness bill), that’s $1 trillion less that needs to be paid for. Without a bipartisan deal at least on the broad infrastructure, that means Democrats will likely include it in a reconciliation bill.
Still, if (and that’s a big if) Democrats can employ these measures to whittle down the tax figure, that probably leaves them needing $1–2 trillion in new tax revenue over 10 years.
Notable Corporate Tax Hikes
Corporate Tax Rate
Treasury green book:
- Increase corporate income tax rate from 21 to 28 percent (raises $858 billion)
- Effective after December 31, 2021; effective for portion of taxable year that occurs in 2022 if the taxable year begins before January 1st
Outlook: The Democratic votes are there to raise the corporate tax rate, with the final figure somewhere in the 25–28 percent range. Where Democrats land on the corporate tax rate will influence the international tax reform measures, as well as the need for potentially more revenue (or less spending/more deficits) if they can’t get up to 28 percent.
International Tax Reform
Treasury green book:
- Increase the global minimum tax (GILTI) from 10.5 percent to 21 percent (75 percent of a 28 percent corporate tax rate), implement GILTI on a country-by-country basis instead of a global average, eliminate the 10 percent qualified business asset investment (QBAI) deduction, repeal the high tax exemption to subpart F income, and broaden the definition of an inversion transaction (effective after December 31, 2021; inversion provision effective for transactions that are completed after the date of enactment) (raises $534 billion)
- Repeal the reduced tax rate on foreign earnings from US-based intangibles (FDII) (effective after December 31, 2021) (raises $124 billion)
- Replace the base erosion and anti-abuse tax (BEAT) with a new rule (SHIELD) that will deny deductions to foreign corporations on US-based payments if they are based in a country that is below a “designated minimum tax rate” defined as either the agreed upon rate from the G20/OECD negotiations or the GILTI if no international agreement is reached (effective after December 31, 2022) (raises $390 billion)
Outlook: There is a real desire for international tax reform but what those provisions look like will depend on where Democrats land on the corporate tax rate and the development of the G20/OECD talks. Without the belief a deal will be reached on the international stage, congressional Democrats will be hard-pressed to meaningfully push forward on Biden’s corporate tax proposals to pay for the AJP. Before the G7 agreement, House Ways and Means Committee Chair Richard Neal (D-MA) said, “I think the timing on it is going to be important because I would like some sort of harmony with what OECD is going to do. I don’t think we should volunteer something and then they lower their rate or something like that.”
Even with a deal reached at the G20, we expect Democrats will temper Biden’s proposed rate increases. What Biden proposed is a bit different from the international tax framework released in April by Senate Finance Committee Chair Ron Wyden (D-OR), Senator Sherrod Brown (D-OH), and Senator Mark Warner (D-VA). That framework was more measured than Biden’s proposals. It included the following:
- Increase the GILTI from 50 percent to 60–100 percent of the US corporate tax rate
- Divide global income in two buckets — low-tax countries and high-tax countries — with the GILTI only applying to the low-tax bucket
- Eliminate the QBAI deduction
- Modify FDII to keep factories in the US and incentivize continuous innovation and investment
- Modify BEAT to ensure the full value of domestic business tax credits and create a second higher minimum tax on actual base erosion payments
Now reaching or the belief that a G20/OECD deal can be reached may make Democrats more inclined to go with the upper range of the GILTI rate and do it on a country-by-country basis. Anti-inversion regulations will also likely be included. But figuring out whether to reform or repeal FDII and BEAT remains up in the air. Given the administration made the effective date for replacing the BEAT with the SHIELD for the end of 2022 instead of 2021, there’s an acknowledgement of its complexities and challenges for implementation.
US Minimum Book Tax
Treasury green book:
- Impose a 15 percent minimum tax on worldwide book income for corporations with such income in excess of $2 billion (raises $148 billion)
- Effective after December 31, 2021
Outlook: While this makes for a good talking point and is the most politically popular tax proposal to pay for infrastructure, it’s not likely to be included in legislation. As of now, there are no critical supporters of the minimum book tax among the upper ranks of Democratic tax writers. The one person who is championing it is Senator Elizabeth Warren (D-MA). Warren may be popular on Twitter but she’s the lowest ranking Democrat on the Senate Finance Committee. Other tax writers, like Wyden/Brown/Warner, have their own international tax framework to combat shifting profits overseas. It’s also unclear how a minimum book tax on worldwide income would interact with these international provisions.
In reality, the complexities of instituting such a minimum book tax makes it more trouble than it’s potentially worth. There are differences between financial accounting standards, which are set by independent organizations like the Financial Accounting Standards Board (FASB), and tax standards, which are set by a political Congress. Mixing the two together would create a headache that pushes corporations to minimize their financial profits and politicize accounting standards. It could also clash with certain tax policies, like immediate expensing of capital investments that is meant to spur economic growth, with financial accounting standards that evenly spreads out the cost over the life of an asset. While there’s a path to some tax increases, there are likely enough business-friendly Democrats who would be receptive to arguments that this is overly complex and should not be implemented.
Notable Individual and Investor Tax Hikes
Treasury green book:
- Increase top marginal individual income tax rate from 37 to 39.6 percent, with an applicable threshold of $509,300 for married individuals filing a joint return, $452,700 for unmarried individuals (other than surviving spouses), $481,000 for head of household filers, and $254,650 for married individuals filing a separate return (effective after December 31, 2021) (raises $132 billion)
- Ensure all pass-through business income for those making above $400,000 is subject to the 3.8 percent Medicare tax, either through the net investment income tax (NIIT) or Self-Employment Contributions Act (SECA) tax (effective after December 31, 2021) (raises $237 billion)
Outlook: Raising the top marginal income tax can get sufficient Democratic support. Although, there may be tinkering on the thresholds for the top rate by Congress.
While raising the top marginal income tax rate is straightforward, applying the 3.8 percent Medicare tax is not. How it impacts the structuring of limited partners and certain S corporation shareholders will likely bring out some powerful interests in this space. For the amount of revenue it’s projected to raise, there has been little discussion of it among lawmakers, likely owing to its complexity. That’s not to say there won’t be some changes here, but its complexity in implementation could leave it on the sidelines.
Capital Income and Inheritance Taxation
Treasury green book:
- Tax capital gains as ordinary income for individuals and couples who make more than $1 million per year (retroactively effective April 28, 2021) and eliminate the step-up in basis after a $1 million per-person exemption and $250k per-person exemption for a principal residence (does not apply to family-owned businesses and farms where heirs continue to run the business) (raises $322 billion)
Outlook: These are Biden’s tax provisions that have received the most pushback from Democrats in Congress. On treating capital gains as ordinary income, Senator Bob Menendez (D-NJ) said, “It seems like a rather high rate to me.” Senator Mark Warner (D-VA) said, “There needs to be some differential” between capital gains and ordinary income, although he’s “open to narrowing that” differential. Senator Jon Tester (D-MT) last month called Biden’s step-up proposals “a non-starter.” He’s joined by several Democrats from rural states and districts voicing concerns about the impact of these provisions on family-run farms and small businesses.
Someone like Senator Wyden is a progressive champion of changing the taxation of wealth. He has put forward in the past a framework that included taxing capital gains as ordinary income, instituting a mark-to-market tax system for tradable assets, and instituting an anti-deferral tax system on the sale or transfer of non-tradable assets. With the latest ProPublica release of confidential tax records of the richest Americans, Wyden responded to the data this week noting that he’ll have a proposal “ready to go here shortly” that would address the taxation of such wealth.
But tax policy isn’t so challenging when it deals with the 25 richest Americans. It’s challenging when it deals with a broader subset of Americans — still wealthy — but also influential in the political process. What Wyden proposes is likely going to pit him against other Senate Finance Committee members and certain moderate Democrats. While Wyden is the most senior tax writer in the Senate, he’s unlikely to get the necessary unanimous support for his framework.
That same battle is happening with Biden’s proposals. If Biden’s step-up provision is pared back or completely nixed, it would impact where Democrats would land on raising the top capital gains rate. Without changing the step-up in basis, treating capital gains as ordinary income would score as costing revenue since investors would hold on to their investments to avoid realizing those gains. Instead, the revenue maximizing rate for capital gains without step-up is estimated to be around 28 percent. That happens to be the capital gains rate President Obama proposed at the end of his second term. Democrats like Menendez and Warner are amenable to raising the capital gains rate, just not to the ordinary income level. That makes 28 percent our continuing base case for where the capital gains rate lands. Unless there are further carve outs in the step-up proposals, it’s possible it could be completely scrapped. If there’s a significant paring back of the step-up proposals, as well as limiting the capital gains rate to 28 percent, then there may be less pressure to make any capital gains hike retroactive.
Certain Preferential Tax Treatments
Treasury green book:
- End the current tax treatment of carried interest for those making more than $400,000 (effective after December 31, 2021) (raises $1.5 billion)
- Limit amount of capital gain deferred under Section 1031 like-kind exchanges to $500,000 for individuals and $1 million for couples (effective after December 31, 2021) (raises $20 billion)
- Make the limitation on deductions of excess business losses permanent (effective after December 31, 2026) (raises $43 billion)
Outlook: The limitation on excess business losses will likely be implemented. It has been used as pay-for by both Republicans and Democrats in the past — it’s why it won’t become effective until 2027 as Congress has already limited the deductions for the years leading up to 2027.
It’s policies limiting and ending carried interest and Section 1031 that are the toughest measures to gauge right now. These relatively small pay-fors play more of a messaging role than a substantial policy role. Publicly, it’s all the usual suspects in the House and Senate who are co-sponsoring legislation to end the preferential tax treatment of carried interest. But there are no new Democratic names that would indicate there is new support. In the Senate, the real test on carried interest will be in a 14–14 Senate Finance Committee. It won’t be what Wyden does — he’s been a long-time opponent of carried interest. Rather, it’s what some of the other senior members, who in the past have shown a willingness to listen to private equity and venture capital interests, do. This includes Menendez, as well as Senators Debbie Stabenow (D-MI) and Maria Cantwell (D-WA). It’s one thing for Democrats to support the idea or a bill ending the preferential tax treatment of carried interest when you’re in the minority or this little chance of it passing. However, the dynamics can be different when there’s a real chance legislation gets enacted.
In the House, it’s clear Neal does not want to lean into Democratic messaging and policy of tax increases like the White House and his counterpart in the Senate. But radio silence doesn’t necessarily mean he won’t support certain tax increases to pay for the spending. Yet carried interest isn’t a real revenue raiser. So it’s a question of whether Neal will go against some of his biggest financial backers in the private equity industry. He has shown a willingness to support them before in the face of Democratic opposition. But the pressure may be too great this time around.
President Obama proposed eliminating carried interest and limiting Section 1031 to $1 million in his final budget. Biden’s limitation of Section 1031 is already a major walk back from his campaign’s estimated $223 billion in real estate rollbacks. While there’s little public talk of this provision, the political challenges of changing this is likely even greater than carried interest, as the relevant real estate and farm interests have Democratic allies.