Republicans Are Wrong: Taxes Are On the Table in Next Fiscal Go-Round

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By Deborah Solomon

Today's vote by Congressional Republicans to temporarily lift the nation's borrowing limit tees up another budget battle, one that will invariably focus on taxes.

Wait, you say, Republican leaders in Congress are loudly refusing to consider new taxes as part of upcoming deficit talks, with Senator Mitch McConnell calling the tax issue "finished, over, completed."

Except that it isn't. In fact, legislation passed on the eve of the fiscal Armageddon almost guarantees taxes -- both individual and corporate -- will be front and center in the next round of fiscal talks.

Why? Well, the 2012 American Taxpayer Relief Act may have prevented the U.S. from tipping into recession by raising taxes only on the wealthiest Americans, but it also created a bigger mess of an already-disheveled tax code. This, combined with the $1.4 trillion in deficit savings lawmakers must find to stabilize the debt, will invariably thrust taxes onto the table.

As a Bloomberg Government study points out, among the trouble spots are that the 2012 law inverts the top tax rates so the highest individual income tax rate (39.6 percent) now exceeds the top corporate rate (35 percent). This inversion, which hasn't occurred since 2002, is likely to inflame Republicans, who claim higher individual taxes will hurt small businesses and stifle job creation.

The law also reinstated confusing and varying limits on itemized tax deductions and exemptions for certain higher-income taxpayers (generally individuals earning above $250,000). Given the intent behind the change -- limiting the value of costly tax expenditures -- it's hard to see how lawmakers don't embrace a cleaner approach and one that generates more revenue for the U.S. The White House estimates the limits on tax breaks will raise $152 billion over 10 years (when benchmarked against the Congressional Budget Office's current policy baseline), but a flat $50,000 cap on tax deductions could raise at least double that amount -- with the burden falling most heavily on the top 1 percent of earners.

These changes will likely propel taxes into the discussion, which would be a welcome development and an opportunity for lawmakers to enact the kind of tax reform leaders in both parties say they want. As Bloomberg Government notes, Congress will want to address the corporate tax rate inversion "in some fashion to bring into closer alignment the top corporate and individual tax rates, which will create a more level playing field for business investment."

To avoid paying corporate taxes, many small-business owners report profits on their individual tax returns. Such “pass-through” entities include sole proprietorships, partnerships, limited liability companies and S corporations. As Bloomberg View editors have written, many of these companies aren’t engaged in traditional small-business activity and are instead partners in hedge funds, law firms and private-equity shops. Fewer than 3 percent of small business owners fall into the upper-income bracket affected by the tax increase, but those filers account for half of all pass-through income, giving Republicans a potent argument for revamping the corporate tax code.

This should be doable, given both parties have sounded similar notes about wanting reform that lowers the statutory corporate tax rate while broadening the base of tax-paying corporations. The White House last year outlined its "revenue-neutral" blueprint of how to get there, offering to lower the rate to 28 percent and make up the difference by closing loopholes, ending certain tax subsidies and other changes. Republicans say they're all for lowering the rate but argue it doesn't need to be revenue-neutral since a lower rate will spur macroeconomic growth (which, in turn, will lower the deficit). This is a divide that can be bridged, perhaps not easily but without great difficulty if both sides agree to compromise.

Limiting tax breaks was also a bipartisan theme in earlier fiscal cliff talks, with both parties suggesting it was time to reduce the value of tax expenditures that cost the U.S. $1 trillion per year. The new law does this to some extent, but taxpayers will need a good accountant to figure out how to calculate what they owe (one look at this Tax Policy Center explainer shows why). The law reinstates the "Pease" limitation on itemized deductions (named after former Ohio Democratic Representative Donald Pease) and the personal exemption phase-out. Both limit the exemptions and deductions for taxpayers who exceed certain thresholds ($250,000 for individuals, $275,000 for heads of household and $300,000 for married couples).

President Barack Obama has offered his own, more streamlined version of the same idea -- limiting the benefit of deductions for people in the higher tax brackets by treating them as if they were in the 28 percent bracket. The plan would increase revenue by more than $288 billion over the next decade. Republicans have also suggested setting an overall cap, which could bring in significantly more money than Obama's plan or the reinstated limits.

The bottom line is that it's hard to see how lawmakers will avoid talking taxes during the next round of fiscal discussions. Doing so is actually in both parties' interest and can help clean up a cluttered tax code, lower the tax burden for corporations and also raise some revenue for a cash-strapped nation.

(Deborah Solomon is a member of the Bloomberg View editorial board. Follow her on Twitter.)

-0- Jan/23/2013 18:59 GMT