TAXES AND THE ELECTIVE PROCESS

1. TAXES AND THE ELECTIVE PROCESS From the Campaign Trail to the Sausage Factory May 20, 2008 John E. Chapoton Alice S. Paik Brown Advisory Washington, DC

2. Summary: I. The setting in which the tax issues are being presented II. The positions of the candidates III. The impact of the budget deficit on the next president IV. What will happen?

3. I. The setting in which the tax issues are being presented

5. Taxes – the immediate issues • Two events will force the new president to act on taxes: • The expiring Bush tax cuts • The spreading AMT “blob” • The next president must have positions on both • Each candidate does • But the ground is shifting as we speak • And of course the candidates are advocating other tax changes • That’s what candidates do…. 2

6. Tax confusion – sunset of the Bush tax cuts Bush Tax Cuts & Sunsets: Current Law Tax legislation Rate Through 2010 Rate After 2010 Tax rate on dividends 15% up to 39.6% Tax rate on LT capital gains 15% 20% Individual Income Tax Rates 10% 15% 15% 15% 25% 28% 33% 36% 35% 39.6% Estate Taxes Top rate falls from current 55% rate of 45% to 0% in 2010 Gift Taxes Top rate falls from 55% current rate 45% to 35% in 2010 3

7. Understanding the budget figures • OMB (the Office of Management & Budget – i.e., the Administration) produces a budget projection each year • The past years reflect actual numbers • The future years reflect the then current Administration’s policy proposals – however unlikely adoption might be – and the economic impact thereof • CBO (Congressional Budget Office also produces a budget projection each year • Assumes current law will remain unchanged for future years, however unlikely that assumption is • CBO estimates are supposed to be untainted politically, but they are also unrealistic in a sense 4

8. Understanding the budget figures (% of GDP) Surplus/ Deficit(-) -2.7 -3.1 -4.7 +2.4 -2.9 +0.3 Surplus/ Deficit(-) -2.7 -3.1 -4.7 +2.4 -2.5 +0.6 OMB CBO Receipts 19.0 18.1 17.5 20.9 17.9 20.0 Outlays 21.7 21.2 22.1 18.4 20.4 19.4 Year 1980 1988 1992 2000 2008E 2012E Receipts 19.0 18.2 17.5 20.9 17.6 18.8 Outlays 21.7 21.3 22.1 18.4 20.5 18.5 Source: CBO; Joint Committee on Taxation 5

9. Budget impact of extending the Bush tax cuts 10-yr Budget Impact of keeping Bush rates Individual tax rates: Present law: 10%-35% 2011: 15%-39.6% Cap gains & dividends: Present Law: 15% 2011-(LTCG): 20% (Div): 39.6% (2008-2017) -$1.22 Trillion* -$208.5 Billion* *Source: CBO; Joint Committee on Taxation 6

10. Budget impact of extending the Bush tax cuts (cont’d) Estate Tax/Gift Tax Present law: • 2008-09: 45%;$2M($3.5)/45%;$1M • 2010: Repeal/35%;$1M • 2011 55%;$1M/55%;$1M 10-yr Budget Impact* (2008-2017)(Billions) • Possible legislative changes effective 2010: • Repeal estate tax….………………………………………..........-$498.8 • $5M exemp./cap gains tax rate…(i.e., McCain)...………….......-$400.9 • Same as #2, but 30% tax rate >$25M ….………………….........-$366.6 • $3.5M exemp./45% tax rate.....(i.e., Clinton & Obama)………..-$231.9 • (all dollar amounts indexed for inflation) *Source: CBO; Joint Committee on Taxation– baseline is 2011 law 7

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12. The Alternative Minimum Tax “Blob” • AMT originally designed (1969) to guarantee that high income individuals pay some minimal level of tax • Excessive use of tax “preferences” (accel. depr., % depl., etc.) would trigger the AMT • It morphed into something quite different • Exemptions were not indexed, so coverage has exploded • 1970 -- 20,000 taxpayers affected • 2007 – 23.4 million taxpayers (without stopgap “patch” legislation) • A third or more of taxpayers could eventually be covered • Encroaching on middle income taxpayers • The top two “preferences” are now the personal exemption and state and local taxes • Is having a large family or living in a high-tax state a tax avoidance technique? • Ridiculous that the tax system penalizes such situations 9

13. The Alternative Minimum Tax (cont’d) • Politicians hate it because their constituents hate it • But…repeal would dig a $668 billion hole in the budget over 10 years (2008-2017)* • And politicians have opted to allow a stealth tax increase vs. repeal and having to deal with the issues that would present • Temporary legislated “patches” are applied to contain the growth of coverage • And there’s the little-mentioned fact that repeal would be regressive – benefiting only upper income and some middle income taxpayers • A problem for Clinton or Obama? *Assumes sunset of Bush tax rate cuts; if rates are extended, which seems likely, cost of AMT repeal would almost double. Stated differently, the pickup from the AMT hides the true revenue cost of the Bush tax cuts 10

14. II. The positions of the candidates

15. The Candidates Step Forward… -- positions on Bush tax rates & AMT • Barack Obama • Same as Hillary • Virtually same as Hillary (<$200,000?) • AMT -- Prevent its spread • John McCain • Extend Bush tax cuts in toto • AMT – Full repeal Hillary Clinton • Repeal Bush tax cuts for top two brackets (i.e., reinstate 36% & 39.6% brackets) • Phil debate pledge: no tax increase for Incomes < $250,000 • AMT – Prevent its Spread 11

16. The Candidates Step Forward… -- positions on capital gains, dividends, E&G Capital Gains Dividends E & G Tax • Clinton • Increase to 20% • No specific proposal • Freeze ’09 estate tax: 45%/ $3.5M • Obama • Increase to 28%, or recently 20% • 0% rate for start-up businesses • Low rate for sale to farmers • Return to ordinary income rates • Freeze ‘09 estate tax: 45%/ $3.5M • McCain • Retain 15% rate • Retain 15% rate • 15% rate/ $5M exemption 12

17. The Candidates Step Forward… -- tax benefit proposals • Obama • Eliminate income tax for seniors <$50,000 • Payroll tax credit up to $8,100 • Mortgage credit • College expense credit • Increase EITC • Increase child care credit • Savers credit • Incentives for renewable energy • Business: • 20% credit for investment in small bus (<$50,000) • McCain • Double PE for dependents to $7,000 • Suspend gas tax for summer • Require 3/5 majority in Congress to raise taxes • Suspend gas tax for summer Business: • 1st year expensing of equip. & technology costs • Reduce corporate rate from 35% to 25% Clinton • Refundable retirement credit • American retirement accounts • Care-giving credit • Long term care credit • Broaden R&E credits • Broaden EITC • Broaden Hope Credit • Reform CDCTC • Double elderly standard ded. • Suspend gas tax for summer 13

18. The Candidates Step Forward… -- loophole closing proposals • Obama • Tighten offshore haven rules • Eliminate “special interest loopholes” • Remove $102,000 cap on FICA tax (top marginal rate on earned income would become 47.25%) • Tax carried interests as ordinary income • McCain • “Close corporate tax loopholes” Clinton • End tax breaks for companies moving abroad • End tax deferral of foreign subs • Tighten transfer pricing rules • Tighten foreign insurer rules • Tax carried interests as ordinary income 14

19. Scoring the candidates tax proposals • Impossible to score the tax proposals except in order of magnitude • Insufficient details • Tax and spending proposals jumbled together • In general terms: • McCain is the grand winner – one cost estimate ot McCain’s tax proposals – $5.7 trillion over 10 years (twice the cost of Bush 2001-03 tax cuts) • Clinton & Obama proposals are similar to each other • Lost revenue is about one-third of McCain’s • Both provide specific pay-fors • Obama’s are somewhat more expensive, net • On the spending side of the budget – who knows how much the candidates are promising to give away? Note: We are purposely avoiding discussion of the candidates’ health care proposals, even though tax law changes are involved. 15

20. What are they thinking?(Have they looked at the budget numbers?) • The projected budget deficit is the 1000 pound gorilla in the room • Its consequences will significantly limit the next president’s options • And will alter the candidates tax proposals long before they become law, or even specific proposals made to Congress • The Candidates are in denial, but understandably so— • No one ever has made it to the White House on promises of cutting spending or raising taxes. • Nevertheless, we may be witnessing a new record in candidate unreality…. 16

21. III. The impact of the budget deficit on the next president

22. The Budget Deficit & The Ever-Growing National Debt Interest All Other Medicaid Medicare Average Tax Revenue Social Security Source:  Congressional Budget Office, December 2005, High spending outlook

23. The budget deficit & the ever-growing national debt (cont’d) • Lessons from previous slide: • Revenues -- tend to bump along at 18-19% of GDP; averaging about 18.3% since the 1980s • Deficits -- vary widely year-to-year – recently from 1.2% to 3.6% of GDP; largest deficit was during Reagan, in early 80s, reaching 6% of GDP • But a train wreck is in our future • slide shows Medicare and interest on the debt will soon explode • Next slide shows the principal culprit: • Uncontrolled expenditures -- Increased interest on the debt, and ever-increasing entitlements • No Congressional action required -- we’re on auto pilot 18

24. The budget deficit & the ever-growing national debt (cont’d) Brown Advisory 24 19

26. The budget deficit & the ever-growing national debt (cont’d) • The next slide tells the same story, but brings it closer to us in time • Around 2016 -- during the next president’s 2nd term --defense outlays, interest on the national debt, and entitlements will consume all Federal revenues • Producing unprecedentedand unsustainable deficits 20

27. The budget deficit & the ever-growing national debt (cont’d) 21

28. Projected budget deficits indicate tough political choices ahead • The good news– these deficits won’t happen • But they will limit the next president’s options -- after about 2016 any spending on education, the environment, welfare, infrastructure and most other domestic programs will require choosing to do one or more of the following: • Increase the deficit (which can’t be sustained); • Rescind tax cuts, or increase taxes; • Reduce social security and health benefits (i.e., renege on what has been promised taxpayers); and/or • Reduce defense spending 22

29. Can the new President simply ignore these budget projections? • Answer: No • While there are complaints about budget forecasts – unreliable; not dynamic; politically motivated, etc. – the forecasts cannot be totally dismissed • These are the official figures that Presidents (and Presidents-Elect) must live by • Candidates are obviously not so constrained • The data are available to all, and are closely examined by think tanks; economists; etc. • Any major, off-the-wall deviations will condemn a president’s proposals to ridicule • Minor deviations might work: • Reagan assumed of 4% real growth for entire budget period, and promised spending cuts to be “supplied later” • In this setting, use of the often-editorialized easy ways out -- the “fiscal myths” -- won’t work 23

30. The Fiscal Myths* • We can grow our way out of difficult budget choices. • Eliminating waste will solve the deficit problem. • The deficit problem can be solved by delivering health care more efficiently. • We just need to raise taxes, and roll back the Bush tax cuts. • Cutting taxes will increase revenue. • Each of these approaches could help, but even all taken together would not begin to solve the problem • A meaningful solution will require telling the public there must be prioritization…leaving some promises unfulfilled, and inflicting some pain • Life will not be simple for our next leader; political leaders don’t like to inflict pain *Brookings-Heritage Fiscal Seminar, April 2008 24

32. IV. What will happen?

33. What will happen – as a practical matter? • “Facts are difficult things” • The winner – the President-elect – will have to reconfigure his or her campaign proposals • Proposing legislation to Congress different than spinning campaign rhetoric • Must contain a greater degree of budget realism • Defer some pet tax and spending promises to the “out years” • McCain advisor: “Don’t look at year 1 & 2 impacts; look longer term” • Search for some almost-credible way to project a balanced budget during his or her tenure • And then begin the difficult negotiation process with Congress 25

34. Recent Presidents…offer any lessons? • Ronald Reagan (1981) – proposed a 30% across-the-board tax cut and dramatic increases in business depreciation deductions • Budget deficit had been about 2.5% of GDP, but Congress gave him most of what he requested – deficit rose to 6% by 1984 • Reagan cooked the books slightly: • Proposed major spending cuts, but balance the books with 4% “unidentified future cuts” • Also, made the deficit problem much smaller by assuming huge real growth in the economy (4% for his budget years) • Geo. H.W. Bush (1988) – promised “no new taxes” • Deficit was well over 3% of GDP • Reality required a compromise budget deal including tax increases, along with spending cuts in 1990 – destroyed his credibility 26

35. Recent Presidents…any lesson? • Bill Clinton (1992)– deficit was high; campaigned on fiscal responsibility • Deficit 4.5% of GDP; economy struggling from 90-91 recession • Proposed significant tax increases in his first year – raised top rate to 36%; 10% surcharge (effective 39.6% rate); removed cap on Medicare 2.9% withholding; raised corp. rate to 35%; increased tax on SS; increased gas tax • Economy still did very well; stock market boomed • 1994 Republicans seized control of House and in ’97 lowered cap gains rate to 20%; increased IRA limits • Economy and stock market boomed further • Geo. W. Bush (2000) – came to town riding his predecessor’s surplus – no deficit, budget in surplus • Campaigned on tax cuts to return the surplus to the taxpayers • Achieved virtually all he requested in record time – by May of his initial year as President • Had an encore two years later – a second round of major tax cuts was proposed and passed 27

36. Big Spending Presidents Percentage Point Change in Domestic Outlays as a Percent of GDP Big Spenders Pikers 28 *2001-2006 only

37. How we raise the money they spend – mainly income and payroll taxes 29

38. The Crystal Ball – tax changes under the next president • My assumption: both Houses of Congress will be controlled by Democrats • If Clinton or Obama is elected… • The pressure to increase tax revenues will be tremendous • To support new and enhanced benefit programs and tax cuts at the bottom; & contain deficit • But don’t ignore power of the Republican minority’s opposition • “The power of 41 Senators….” • As a practical matter, it will take 60 votes to increase taxes 30

39. Tax changes under the next president – Clinton & Obama • Income tax rates… • Rates at top very likely to go up – 36% and 39% brackets likely to be reinstated (as promised by the candidates) • Note: Second-to-top rate kicks in at $200,300 • Perhaps increase in rates in some lower brackets as well • Both candidates have said no increases for taxpayers under $250k of income (Obama $200k?) • But that excludes 97% of all taxpayers • Makes meeting their budget projections hard, and a meaningful compromise on spending and taxes difficult 31

40. The Crystal Ball – tax changes under the next president (cont’d) • Payroll taxes… • If Obama elected, $102,000 cap on FICA likely to be adjusted upward, but I doubt removed entirely • Would cause top rate on earned income to become 47.25% • “Doughnut” protection for taxpayers $102,000 to $250,000? • Could graduate the increase in the cap as incomes go up • Clinton has staked out no campaign position on payroll taxes, but this will be a tempting target – would raise billions over 10 years • A step toward means testing social security • AMT repeal… • Unlikely by either Democrat candidate – far easier to temporize; there’s simply no room in the budget and deferring repeal is very tempting 32

41. The Crystal Ball – tax changes under the next president (cont’d) • Capital gains… • Rate definitely rises – but well short of 28%; more likely to 20% or 25% • This is not a major revenue raiser, but neither does it affect a large group of taxpayers (only 14 million taxpayers reported capital gains in 2005) • Remember, all gains inside a qualified plan (IRA, 401(k)), etc., are taxed as ordinary income eventually • Dividends… • 15% rate at extreme risk • Only hope is some tie to the capital gains rate, but don’t bet on it; no historical support • Again, 15% rate is no benefit to qualified plans 33

42. The Crystal Ball – tax changes under the next president (cont’d) • Candidates tax benefit proposals… • Some will make it but many won’t, at least in the first round -- No room in the budget • Rules of the lobbying jungle will determine winners • Candidates loophole closers… • Not a slam dunk even in times of budget crisis • Most raise relatively little revenue • And for most lobbyists opposing these changes, “This is not their first rodeo” • Yet they have reason for concern…a national mood of righteous indignation could develop if many are being asked to pay more • E.g., carried interests likely to receive much attention 34

43. The Crystal Ball – tax changes under the next president (cont’d) • Estate & Gift taxes • A compromise will clearly be worked out by 2010 • Many Democrat members have a dog in this fight • Something more beneficial than the Clinton and Obama proposals seems likely • Their proposal: freeze the 2009 rules (45% rate & $3.5M exemption) going forward • Traditional wisdom: Democrats want larger exemption/Republicans want lower rates • But many Dems want lower rates as well • More generous compromise – e.g., rate 35%-40%; exemption $3.5M to $5M –seems doable even under a Democrat administration 35

44. Tax changes under the next president -- McCain • If McCain is elected… • The budget picture will be the same, but the tax result is likely to be very different • As stated, I assume Democrats will control both the House and the Senate • But even if that is correct, it doesn’t mean McCain’s proposals can be written off. • Never overlook the clout of a newly-elected President to get his initial program through, even with an opposing Congress • The people – and thus the Congress – want to give him a chance to see what he can do • McCain has staked out a deep tax-cutting agenda • Once he’s the president-elect his tax agenda cannot be treated seriously without accompanying proposals for deep – unprecedented – cuts in spending • He would exempt Defense spending from the knife • Hard to see how he could avoid a cut in entitlements 36

45. The Crystal Ball – tax changes under the next president (cont’d) • McCain’s situation is very similar to Reagan in 1981 • Reagan 1981 proposals to Congress: • Unprecedented tax cuts for both individuals and corporations • Huge spending cuts, but Defense (and entitlements) untouched • Reagan faced a Democrat House, but Republicans had seized the Senate • He rode in on a wave of hope • And Congress gave him almost all he proposed • But it produced unprecedented deficits • 6% in FY 1983 • The long term budget squeeze was nowhere near as bleak as it is today • Likely this history not lost on McCain • McCain’s team will need lots of smoke and mirrors 37

46. The Crystal Ball – tax changes under the next president (cont’d) • How would a Democrat-controlled Congress react to McCain’s proposals? • Strong opposition; but the Democrats do not want all of the Bush tax cuts to be killed • McCain could threaten veto of tax increases Congress might enact, and override would be unlikely • The credibility of his spending cuts to offset tax cuts would be a factor • McCain may be compelled to compromise compelled by sunset scenario: Without legislation all rates increase to 2000 levels in 2011 – neither side wants that, so each side has leverage 38

47. The Crystal Ball – tax changes under the next president (cont’d) • Specifics: • Bush cuts in tax brackets… • McCain could save most but would likely need to concede at the edges – top rate might inch higher • AMT – likely continue the “patch”; he has bigger fish to fry • Capital gains & dividends… • McCain would oppose increases, but might have to compromise 38A

48. The Crystal Ball – tax changes under the next president (cont’d) • McCain’s goodies… • Double exemption for dependents • Possible • Corporate rate cut (35% to 25%) • Very doubtful even with a strong McCain administration push • Proposal does have strong corporate backers • 1st year “expensing” for business equipment & technology investments • Loophole closers… • Clinton/Obama list would virtually disappear • If the “tax increase” label can be avoided, some might pass -- even Reagan supported raising revenue by closing many tax avoidance techniques 39

49. The Crystal Ball – tax changes under the next president (cont’d) • Estate & Gift taxes • Doubtful McCain could maintain his campaign position – 15% rate and $5M exemption per spouse • Tantamount to repeal in revenue terms • But ultimate compromise under a McCain administration would likely be more generous than under a Democratic administration • Again, our guess: Exemption of $3.5M to $5.0M; tax rate of 35% to 40% 40

50. The Crystal Ball…becomes fuzzy • In the end, any new president’s legislative success will depend on the mood of the country • Congress reluctant to appear defiant to the new boy in town • Most of the tax issues are not new, nor are the arguments pro and con • The results will probably swing on… • The procedural uniqueness of the sunsets, and • The power of 41Republican minority senators • Is a stalemate on taxes possible? • Not likely; America has made clear--We want government to function • WHY WOULD ANYONE WANT TO BE PRESIDENT? 41