Painful choices ahead as Congress contemplates paying for tax cuts

There has been a spate of reports in recent days suggesting that the Senate may be willing to consider one or more international tax provisions as well carried interest legislation to pay for tax relief initiatives it intends to take up this year.

The heightened focus on these specific tax increases – and, more broadly, on the specter of significant business tax increases – is a natural result of two forces:

- The adoption of statutory pay-as-you-go budget rules that require most tax cuts to be offset with corresponding tax hikes or spending reductions and

- The recent enactment of a series of relatively "easy" revenue raising provisions – codifying the economic substance doctrine, making "black liquor" ineligible for the cellulosic biofuel producer credit, and imposing new corporate payment reporting and foreign account information reporting requirements – in the health care reform bill and the Hiring Incentives to Restore Employment Act.

Our bottom line is that these two forces significantly increase the risk of adverse business tax legislation this year. The current legislative agenda includes extension of expired and expiring provisions, jobs legislation, and a possible package of renewable energy incentives. These initiatives could easily require a total of $70 billion in revenue offsets.

Two additional tax priorities – a permanent estate tax resolution and legislation preventing the top qualified dividends rate from reverting to 39.6 percent next year – also would require offsets. According to the Joint Committee on Taxation (JCT) staff, simply making 2009 estate tax law permanent would cost in excess of $200 billion. Although the JCT has not published an official estimate on the cost of preventing the qualified dividend rate from reverting to ordinary income tax rates, that cost could approach $100 billion.

The list of "easier" revenue raising provisions that are still available to Congress is extremely short and likely would generate less than $30 billion at the upper limit. These include pension funding relief, a handful of compliance items, and possibly extension of the unemployment compensation surtax. As a result, Congress will be forced to confront very difficult choices as it consider proposals related to inventory methods, Superfund taxes, employee classification, international tax, and tax increases targeting specific industries (for example, bank fees and income tax changes for oil and gas, coal, carried interests, and insurance).

Just how difficult these choices can be is clear from the following list of 18 revenue offset options that are estimated to raise more than $5 billion over 10 years. (These provisions have been proposed by the president in his FY 2011 budget or are included in active legislation.)


Compliance provisions
- Increase certainty of worker classification ($6.9 billion).

Extensions of current revenue provisions (FY2011 budget)
- Make permanent the unemployment insurance surtax ($12.8 billion).

Business provisions (FY2011 budget)
- Repeal the LIFO accounting method ($75.3 billion);
- Reinstate the Superfund environmental income tax ($12.8 billion);
- Repeal the lower-of-cost-or-market inventory method ($8.0 billion);
- Reinstate Superfund excise taxes ($6.4 billion).

Financial markets and institutions provisions (FY2011 budget)
- Impose a fee of 15 basis points on the largest firms ($90.0 billion);
- Tax income from carried interests as earned income (28.6 billion);
- Expand the pro rata interest expense disallowance for corporate-owned life insurance ($7.3 billion).

Oil & gas provisions (FY2011 budget)
- Repeal expensing of intangible drilling costs ($10.9 billion);
- Repeal the domestic manufacturing deduction for oil and gas production ($14.8 billion);*
- Repeal percentage depletion for oil and natural gas wells ($9.7 billion).

International provisions (FY2011 budget)
- Determine foreign tax credits on a pooling basis ($49.2 billion);*
- Defer deductions of interest expense related to deferred income ($35.5 billion);*
- Tax current excess returns associated with transfers of intangibles ($10.2 billion);*
- Prevent splitting of foreign income and foreign taxes ($9.5 billion);
- Modify tax rules for dual capacity taxpayers ($8.2 billion);
- Limit treaty benefits for certain deductible payments ($7.7 billion).

(*Most observers in Washington believe that the three largest international revenue raisers cannot be considered outside of
the context of substantial corporate tax reform. Similarly, many believe that curtailing the production activity deduction
would be appropriate only in the context of a corporate rate reduction.)

The next opportunity for Congress to act on significant revenue raisers is likely to emerge between now and Memorial Day
as the House and Senate attempt to reach an agreement on extending expired provisions. (A one-year extenders package
approved by the Senate in March would cost an estimated $33.7 billion over 10 years; a one-year House package approved
in late 2009 would cost $31 billion.)