Payroll Tax Tiff Times 25 Awaits Congress in ‘Utter Dysfunction’

The brinksmanship in Congress over a payroll tax-cut extension may end up looking like a quaint disagreement by next December, when lawmakers must grapple with a fiscal policy debate at least 25 times more costly.

Unless Congress acts by the end of 2012, income tax cuts will expire, automatic reductions in defense and domestic spending will start and the alternative minimum tax will ensnare millions more taxpayers. The same Congress that can’t find a way to extend the widely supported payroll tax cut beyond Dec. 31 will be seeking to bridge long-held ideological differences.

“The prospects are bleak,” said Leonard Burman, a former Treasury Department official who teaches public affairs at Syracuse University in New York. “I’ve never seen such a high level of dysfunction in the 25 years or so that I’ve been paying attention to government.”

The year-end 2012 series of deadlines on tax and spending policy stems from Congress’s tendency to push problems into the future with temporary solutions. This year alone, lawmakers have flirted with a federal government shutdown three times, almost defaulted on the U.S. debt for the first time in history and allowed aviation taxes to lapse for two weeks.

The income tax cuts, first enacted in 2001 and 2003 under President George W. Bush, were scheduled to expire at the end of 2010 for budgetary and political reasons and were extended two more years by Congress and President Barack Obama. The spending cuts are a byproduct of a 2011 agreement to raise the federal debt limit.

Trillions at Stake

The $4 trillion in expiring tax cuts and $1.2 trillion in potential spending cuts dwarf the $200 billion at stake in the current fight over the payroll tax cut and other provisions, including expanded unemployment insurance. Those items, if extended for another year, would expire at the end of 2012.

House leaders, Senate leaders and Obama are blaming one another for the stalemate. House Republicans insist on a yearlong extension. Senators from both parties backed a two- month extension on Dec. 17 to buy time for negotiations on a longer-term agreement.

The potential collapse of the payroll tax-cut deal, which would result in lower paychecks for 160 million U.S. workers in January, caps a year in which approval ratings for Congress have plummeted. A Gallup poll released Dec. 19 found 11 percent of Americans approve of Congress’s work. The yearly average is 17 percent, which Gallup said was the lowest annual congressional approval rating it has ever recorded.

“We’ve got some critical issues that are just coming to a head in 2012, and I hope we learn from this experience,” said Representative Tom Reed, a New York Republican and one of the eight would-be House negotiators appointed by Speaker John Boehner on the payroll tax issue.

‘Reckless Policy’

In a telephone interview yesterday, Reed criticized Obama and the Senate for trying to push decisions on policy issues -- such as the Keystone XL oil pipeline from Canada to Texas -- beyond the 2012 election.

“It’s amazing to me that grown responsible men and women will defer to politics and support reckless policy, just because the politics are such that it may be in their interest to do it,” said Reed, who entered the House in November 2010.

Representative Allyson Schwartz, a Pennsylvania Democrat, said Democratic willingness to cut spending hasn’t been met with an equal spirit of compromise from Republicans on taxes.

“This week seems dramatic, but the fact is all year we have been dealing with Republican leadership and a Republican conference that has taken us to the brink of a crisis and an inability to really work in any kind of bipartisan effort,” she said in a telephone interview yesterday.

Expiring Tax Cuts

Unless Congress acts next year, the top income tax rate in 2013 would rise to 39.6 percent from 35 percent. Dividends would be taxed as ordinary income, and the top rate on long-term capital gains would rise to 20 percent from 15 percent. Tax increases for investment income included in the 2010 health care law are also scheduled to take effect in 2013.

In addition to everything else expiring at the end of 2012, Congress also will have to fund the government for the fiscal year that starts Oct. 1, 2012. That issue may linger into December unless lawmakers can reach a pre-election agreement.

Furthermore, depending on economic growth, the federal government may again bump up against the debt limit -- a debate that consumed Washington during July 2011.

If those issues collide simultaneously, including the debt limit, “it would be like a nuclear device being detonated,” said Kenneth Kies, a Republican tax lobbyist in Washington whose clients include Microsoft Corp. (MSFT) and Pfizer Inc.

The political dynamics of fiscal policy will change after the 2012 election, depending on who gains control of Congress and the White House. The new Congress won’t be sworn in until January 2013, and, if Obama loses, his term won’t end until Jan. 20, 2013.

‘Lame-Duck Dynamics’

If Congress can’t resolve these issues before the election, lawmakers will reprise 2010, when a lame-duck Congress controlled by Democrats wrangled over tax policy after Republicans had won control of the House in the election. Under Republican pressure, Obama and congressional Democrats agreed to extend all of the tax cuts instead of ending them for high earners.

“Lame-duck dynamics are entirely predicated on what happens in the election,” said J.D. Foster, a senior fellow at the Heritage Foundation, a Washington group that supports limited government. “They may be the same members, but they’ll be there under very different circumstances.”

Even Obama, who will be president in December 2012 whether he wins or loses the election, will view issues differently without election pressure, Foster said.

Lawmakers are starting to envision scenarios for how the tax and spending issues are reconciled, depending in part on the election results.

Deficit Focus

Earl Pomeroy, a former Democratic congressman from North Dakota who is now a lawyer at Alston & Bird LLP in Washington, said the national focus on the federal budget deficit will make it more difficult for Republicans to press for an extension of the 2001 and 2003 tax cuts without covering their cost.

“For those from the right side of the political spectrum, you’ve got the worst of all worlds,” said Pomeroy, a lobbyist whose clients include Aetna Inc. “If Congress fails to act, you’re going to have a tax increase and steep defense cuts. What we’re seeing with the legislative process is that it’s fallen to a state of utter dysfunction.”

Addressing the alternative minimum tax is the one thing that must be done at the end of next year, said Kies, a former chief of staff of the congressional Joint Committee on Taxation. It is a parallel tax system designed to prevent top earners from legally avoiding taxes.

Indexed for Inflation

The exemption levels aren’t permanently indexed for inflation so, unless Congress works to blunt its spread, millions more taxpayers would end up paying it.

The alternative tax is the only issue in play, Kies said, that will affect tax returns filed in early 2013.

“Nothing else has to be done,” he said.

Reed said he hoped Congress could start debating the provisions expiring at the end of 2012 as early as possible.

“They cannot be dealt with post-election in crisis mode,” he said. “These issues, they don’t get better with time. They get worse.”

To contact the reporters on this story: Richard Rubin in Washington at rrubin12@bloomberg.net; Steven Sloan in Washington at ssloan7@bloomberg.net

To contact the editor responsible for this story: Mark Silva at msilva34@bloomberg.net

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