The $1.2 trillion sequester, AKA the “austerity crisis,” or “fiscal cliff Part 2” takes effect at the end of this week (March 1). Without alternative legislation, $85 billion will be slashed from the rest of this year’s budget. The across-the-board cuts would hit the Pentagon, social services programs, government agencies like the Department of Education, NASA, and National Institute of Health, and reduce payments to Medicare providers.
Most politicians agree that the sequester is, as House Speaker John Boehner put it, “bad policy,” but if you thought collective agreement on a top priority political issue would promote bi-partisan action and compromise, you must have missed the debt-ceiling debates and first round of fiscal cliff negotiations.
New revenues are the biggest stalemate to compromise. The American Taxpayer Relief Act (ATRA), which extended tax breaks for 98% of Americans while raising over $600 billion in new revenue wasn’t enough for Democrats or the White House, who wanted at least twice that. The Republican agenda on additional tax revenue is more divided, with some lawmakers such as Senator Lindsey Graham (R-S.C.) and Arizona Gov. Jan Brewer recently coming out in support of some new revenues in exchange for serious spending cuts. Graham said he opposes the sequester because it’s “a lousy way to cut $1.2 trillion,” and that he would agree to $600 billion in new revenue pending Democratic compromise on reforming entitlements and of course, cutting spending. Meanwhile, on CBS’ Face the Nation on Sunday, Brewer said:
“We know we have to be pragmatic. We know there has to be some kind of compromise, but dang it, they need to get the job done. They don’t need to leave the public out there hanging.”
One idea that’s been thrown around a lot since the election is to close these so-called tax loopholes. The idea is trending in both parties. Just yesterday, Boehner’s press aide Brendan Buck tweeted @ White House Press Secretary Jay Canney, “My daily reminder: Republicans want to close loopholes in the tax codes.”
Compromise, right? Both parties want to close loopholes – seems straightforward. But even if those loopholes could be identified, agreed on, and packaged into yet another “grand bargain,” a compromise is unlikely. The second half of Buck’s tweet says it all:
So while Republicans are willing to close loopholes, they would have to be offset by lower tax rates, creating zero net revenue. Democrats want more revenue, and some Republicans are going so far as to say Boehner could lose his speakership if he caves on taxes this time around. That’s not promising news if you were hoping for a sequester alternative.
For the sake of learning, let’s ignore the hard-liners and try to analyze which tax loopholes could be closed or amended in a fantasy world of bi-partisan compromise. President Obama continues to use the “corporate jet” tax-break as a flagship for this debate, but many consider that proposal more of a political talking point then a real solution. Few in Washington have been specific when it comes to closing loopholes, so the following list attempts to outline some of the more glaring tax-breaks that could be amended as part of a package to curb the sequester.
We defined tax loopholes using Investopedia’s definition: “A technicality that allows a person or business to avoid the scope of a law or restriction without directly violating the law.”
- Foreign Tax Loopholes
- Companies and individuals use accounting gimmicks to mask their U.S. profits as foreign-sourced, costing the federal government up to $100 billion every year. The IRS is investigating these cases (See: Amazon’s Epic Transfer Pricing Strategy) and taking some to court (See: Billions on the Line in Supreme Court Case over Foreign Tax Credits), but without congressional action, loopholes in the tax code will continue to let billions slip away abroad. Sen. Carl Levin (D-Mich.) outlined a specific strategy for eliminating foreign tax sheltering in a bill he sponsored, the Cut Unjustified Tax Loopholes Act, which remains dead in the Senate. According to Levin’s summary, thirty of the largest U.S. multinational corporations, which have combined profits of $160 billion, paid ZERO corporate income tax from 2008 to 2010. The Economist ran a 14-page special report on this issue — The missing $20 trillion, How to stop companies and people dodging tax, in Delaware as well as Grand Cayman — which notes that, “when governments and individuals everywhere are scrimping to pay their bills, attacks are mounting on tax havens and those that use them.”
- The Carried Interest Loophole
- Investment managers have long enjoyed a tax break that allows a cut of profits they receive from their investors to be taxed at the normal capital gains rate. This results in hedge-fund and private-equity managers taking more of their earnings from profits and less from management fees to reduce their tax bill, in some cases by well over 50%. The CBO estimated that ending this loophole would bring in an extra $21 billion over the next 10 years.
- Yachts, Luxury Buses and Vacation Homes
- You’ve probably heard about tax breaks for luxury yachts, but it’s less known that the break stems from what’s called the Second-Home Mortgage Interest Deduction. Second homes are eligible for the same deductions of interest payments as normal homes are, as long as they’re not a business property (not being rented-out). So, if a private yacht has a toilet, kitchen and a bed, it counts as a second home too! The same goes for RVs, luxury buses and vacation homes. Of course, not everyone who owns a second home is rich, but this is definitely a tax-break that could be better defined to make sure that it serves its intended relief purpose.
- Derivatives Blending Rate Loophole
- Derivatives are contracts between parties whose value is determined by fluctuating market prices and are common in financial transactions. Profits from certain derivatives, including commodity futures, benefit from a blended tax rate capped at 23%. Taxing them as ordinary income would generate $28 billion over the next 10 years.
- Excessive Corporate Stock Options
- When employees cash in their stock options, companies get a sizable tax discount. Instead of reporting to the IRS what they do to their shareholders – the original price of the stock – companies use the higher market value of the shares to set against their tax liability. In the case of companies like Facebook, this loophole is so beneficial that they may pay no corporate income tax for a generation. Changing the loophole to limit what companies report to being no greater than what they report to their shareholders and placing a $1 million cap on stock options could generate $25 billion over 10 years.
- The Corporate Jet
- On Sunday President Obama challenged Republicans by asking if they were “really willing to let these cuts fall on our kids’ schools and mental health care just to protect tax loopholes for corporate jet owners.” As an ABC news blogger put it, “Listening to the White House, you’d think the key to averting [the sequester] is closing the tax break for owners of private jets.” The funny part is, the senate Democrat proposal to avert the sequester, which is endorsed by the White House, doesn’t even mention corporate jets. So it’s true that there is a special tax incentive for corporate and private planes (they are allowed to depreciate over a 5-year period rather than the 7-year period required for commercial planes), but it’s not true that it’s a serious part of any proposal to close loopholes. Check out Republican Senators Defend Corporate Jet Tax Loophole for a good analysis of the issue.
There are plenty more gaping loopholes and desperately needed changes to the tax code, but the above list is a good summary of the major targets that lawmakers might focus on in the upcoming weeks. Note that even if all of the above mentioned loopholes were closed, it would only bring in roughly $200 billion over 10 years, less than 10% of what’s needed to reduce the deficit. Take the poll below and tell us what you think the most glaring loophole is!
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- Obama: Republicans want to ‘protect tax loopholes for corporate jet owners’ (rawstory.com)
- Loopholes (bell-book-candle.com)
- ALL About The Sequester From Barack’s Blog (theobamacrat.com)
- All 50 States Will Lose With Sequestration (hispanicbusiness.com)
- Senate Democrats Protect Corporate Jet Loophole (abcnews.go.com)