Autumn 2011 in Washington, D.C. is expected to be a season of contentious debates over tax reform, and at the heart of the debate is the amount of taxes paid by higher-income individuals. President Obama wants Congress to raise taxes on higher-income individuals to help reduce the federal government’s budget deficit and to pay for a jobs program. Many lawmakers, especially Republicans, are opposed to any tax increases. The two sides appear far apart but the need to cut the nation’s deficit could encourage compromise.
Bush-era tax cuts
In 2001, Congress enacted the Economic Growth and Tax Reconciliation Act (EGTRRA), which set in motion a gradual decrease in the individual marginal income tax rates and the federal estate tax, along with marriage penalty relief, the introduction of a new 10 percent tax bracket and more. The Jobs and Growth Tax Act of 2003 accelerated the reductions in the individual tax rates and also reduced capital gains and dividend tax rates (currently taxed at 15 percent for taxpayers in tax brackets above 15 percent and at zero percent for or all other taxpayers). All of these tax cuts are collectively known as the Bush-era tax cuts.
In 2010, Congress passed, and President Obama signed, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act. The 2010 Tax Relief Act extended the Bush-era tax cuts through the end of 2012. The extension proved especially valuable for higher-income taxpayers. Without the extension, the top two individual income tax rates would have risen from 33 and 35 percent to 36 and 39.6 percent, respectively, after December 31, 2010.
White House proposals
President Obama released a Deficit Reduction Plan on September 19 and proposed to allow the Bush-era tax cuts to expire for higher-income taxpayers and to return the federal estate tax to its 2009 parameters. The White House broadly defines higher-income taxpayers for purposes of the Bush-era tax cuts as individuals with annual incomes over $200,000 and families with annual incomes over $250,000.
The President’s Deficit Reduction Plan would:
- Allow the Bush-era high-income tax cuts to expire
- Return the federal estate tax to its 2009 levels
- Reduce the value of itemized deductions and other tax preferences to 28% for families with incomes over $250,000
All of these changes would apparently take place after 2012.
Keep in mind that if Congress does nothing before 2013, the Bush-era tax cuts are scheduled to automatically expire after 2012. Tax rates would not only rise for higher-income individuals but for all taxpayers. The federal estate tax would return to its pre-EGTRRA levels (with some minor modifications) and capital gains/dividends would be taxed at much less taxpayer-friendly rates than under current law.
Additionally, higher-income individuals will pay more in taxes after 2012 because of existing laws. An additional 0.9 percent Medicare tax on wages and self-employment income and a 3.8 percent Medicare contribution tax on unearned income are scheduled to take effect after 2012 for higher-income taxpayers.
President Obama has asked Congress to enact legislation to provide that no household making over $1 million annually should pay a smaller share of its income in taxes than middle-income families. President Obama calls this tax treatment, the “Buffett Rule” after billionaire investor Warren Buffett, who said that his effective tax rate is lower than the tax rate of his secretary.
The White House has been deliberately vague on the mechanics of the Buffet Rule. In his Deficit Reduction Plan, President Obama said that the Buffett Rule would be enacted as part of overall tax reform, which increases the progressivity of the Tax Code.
The Buffett Rule could take the shape of increased taxes on capital gains and dividends. Higher-income individuals typically have a significant portion of their income from investment activity. The Buffett Rule could also reform the alternative minimum tax (AMT). The AMT was originally enacted to prevent very wealthy taxpayers from avoiding taxes. Because the AMT was not indexed for inflation, and for other reasons, the AMT has encroached on middle income taxpayers.
Payroll tax cuts
The 2010 Tax Relief Act enacted a temporary payroll tax holiday. The employee-share of OASDI taxes is reduced from 6.2 percent to 4.2 percent for calendar year 2011 up to the Social Security wage base ($106,800 for 2011). An individual with earnings at or above $106,800 in 2011 receives a $2,136 tax benefit. Self-employed individuals receive a comparable tax benefit. Under current law, the payroll tax holiday ends after December 31, 2012 and the employee-share of OASDI taxes is scheduled to revert to 6.2 percent.
President Obama has proposed to extend and enhance the payroll tax cut for calendar year 2012. The employee-share of OASDI taxes for 2012 would be reduced from 6.2 percent to 3.1 percent, under the President’s proposal.
The President’s proposal has a reasonably good chance of being enacted. Taxpayers have become accustomed to the two percent reduction in effect for 2011. Moreover, lawmakers are reluctant to raise taxes in an election year. However, opponents of any extension question its impact on the long-term health of Social Security.
If you have any questions about the proposals being debated in Washington, please contact us.