We have received a number of questions from clients on what we can expect with the new Administration in Washington. Potential tax increases have been the number one question from clients over the past week. We see fiscal stimulus coming in two parts, with the first package focused on income replacement which can pass by the end of February. The second package, which will likely be considered mid-year, is a more complicated legislative vehicle, focused on long-term structural changes to the US economy and will likely raise taxes.
Moderate Democrats in the House are threatening to vote against rule changes on non-COVID legislation that increase the deficit and Pelosi has little margin to lose votes. Progressive Democrats are focused on tax increases to help close income inequality in the US. Taken together, some tax increases are likely coming. The goal of the new Administration is to have more spending than tax increases (more candy than spinach), but $1 trillion of tax increases will have significant consequences for individuals and businesses.
We take a look at possible tax increases that may be included in a second economic package. Some of these provisions may be retroactive, such as income tax increases, but that is unlikely for capital gains. Our initial list is a moving target, which could change as the economic environment, and the pace of reopening will determine the path of fiscal policy in 2021.
- Increase the Top Marginal Income Tax Rate from 37 to 39.6 Percent: The lowest hanging fruit of potential tax increases is to raise the top marginal tax rate from 37 to 39.6 percent. The President-elect has limited himself on how much money this tax increase will raise by restricting the change to taxpayers with $400k of income. There is some flexibility on the $400k because Biden never specified the tax brackets. This gives Congress some maneuverability, but an increase in the top income tax rate is as likely as any tax increase.
- Lower the Value of Income Tax Deductions to 28 Percent for High Income Taxpayers: Another way to raise tax revenue from high income taxpayers is to reduce the value of their tax deductions. In most instances, taxpayer deductions are roughly equivalent to their tax rate. The Obama Administration proposed to cap deductions for high-income taxpayers at 28 percent. This proposal seems likely to pass, although there will likely need to be an exemption for the charitable and mortgage deductions to make it into law. President Obama’s budget also targeted tax-exempt municipal bonds and employer health insurance. These two items are unlikely to pass in a 50- 50 Senate.
- Reducing the Value of Tax Deductions Allows Congress to Reinstate the State and Local Tax Deduction: In 2017 Congress restricted the ability of taxpayers to deduct their state and local taxes to just $10,000. Restoring the state and local tax deduction (SALT) is a top priority of the Democratic leadership who reside in high tax states facing waves of out-migration (Speaker Pelosi: California, Senate Majority Leader Schumer: New York). However, the reinstatement of the deduction overwhelmingly benefits high-income taxpayers. In isolation, reinstatement of the deduction contrasts with the Democrats’ goal to use tax policy to close the income inequality gap. But raising tax rates and reducing tax deductions elsewhere allows SALT to be reinstated, likely at a 28 percent deduction rather than the full deduction.
- Increase the Capital Gains and Dividend Tax Rate between 25-28%: Given the focus on income inequality, and the differential between wage and investment income, an increase in the capital gains and dividend tax rate is likely. The President-elect has proposed equalizing income and capital gains taxes. He has been of this view for longer than he was a presidential candidate, and we believe he really wants a 40 percent capital gains tax rate. But the political realities of a 50-50 Senate suggest the rate could fall in the range of 25-28 percent. The Joint Committee on Taxation for Congress found the tax-revenue-maximizing rate is 28 percent, which means a rate higher than 28 percent results in less money for the government.
- Talk of an Unrealized Capital Gains Tax, but a Realized Capital Gains Tax Is More Likely: Incoming Senate Finance Chairman Ron Wyden has pushed the concept of an unrealized capital gains tax, which imposes a mark-to-market tax on unrealized capital gains. Our sense is that this proposal is not ready for prime time, given issues around valuing illiquid assets. But countering this proposal is not easy, especially in an environment in which fixing income inequality is a top concern. This year will mark the beginning of this debate, but it is unlikely to make it into law.
- Estate Tax Changes Will Be Proposed, Legislative Math Is Difficult: The President elect has proposed an increase in the estate tax rate, cutting the estate tax exemption in half, shifting from a step up in basis to a carryover basis, and imposing an unrealized capital gains tax on the heir upon asset transfer. The combination of these four items creates a backdoor wealth tax and would mark a significant change in how estates are taxed. We take these proposals seriously, especially given the focus on income inequality. But the legislative realities of a 50-50 Senate make passage of these four items difficult. Senators Manchin and Sinema have voted to repeal the estate taxes during their Congressional careers. Others have sponsored legislation to reduce the estate tax. This argues for Congress being able to raise the rate. Changing from a step up to a carryover basis is possible, but still seems difficult. The same for cutting the exemption, which will put more small business owners and farmers into the estate tax. We are not sure an unrealized capital gains tax is ready for prime time, even if it is limited to just estates.
- Increase in the Corporate Tax Rate from 21 to about 25 Percent Likely Starting in 2022: We could find very few Democrats in Washington who believe the corporate tax rate should be 21 percent. As such, we expect a corporate tax rate increase this year. The President-elect has proposed a 28 percent tax rate. We have been more in the camp of the rate settling around 25 percent. This is consistent with Senators Manchin and Klobuchar’s proposals and at a level where corporate lobbying would be less intense. We estimate this would be about a $40bn tax increase on corporate income annually. Our guess is that the corporate tax rate increase will not take effect until 2022, but that will depend on when Congress gets the legislation completed and the current US economic environment.
- Increase in Corporate Tax Rate Will Trigger Corporate Tax Rate Increases on Foreign Source Revenue: An increase in the corporate tax rate will automatically trigger an increase in tax rates on intangible income of US multinationals. Still, The President-elect has specifically proposed doubling this tax rate from 10.5 to 21 percent and that could have significant implications for technology and biotech companies. We could see a scenario in which the currently scheduled 2026 tax rate of 13.5 percent will come into effect immediately and be implemented on a country-by-country basis.
- The President-elect has Proposed a Minimum Tax on Book Income of 15 Percent, but a Corporate AMT May Be More Likely: The President-elect has proposed a 15 percent minimum tax on book income for companies that report more than $100mm of income, but owe no US corporate tax. This is often referred to as the “Amazon” tax by targeting the company. More broadly, the proposal targets companies that make capital investments which lower their tax bills. Capital investment is highly correlated with job creation. Given the complexity of the program, the minimum book tax looks tough to us right now. We still see an appetite to impose a minimum tax on US corporates, and re-imposing the corporate AMT (eliminated as part of the 2017 tax cut) seems more likely to us. We say this with the hesitation that re-imposing a corporate AMT now would be a large negative given that companies are digging out of the COVID-19 recession.
- Sector Proposals Could Be on the Table but Harder to Get through in Such a Divided Congress: The President-elect has also proposed: 1) Repealing like-kind exchanges for real estate investors; 2) Imposing a risk tax on banks; 3) Removing tax preferences for fossil fuel companies, such as the intangible drilling credit; 4) A new pharma tax on companies that increase drug prices; and 5) Removing the tax deduction for pharmaceutical advertising. Our sense is that broader policy changes will be easier to enact in a large package and that narrowly targeted industry tax increases will be difficult with just 51 votes. Real estate, banks, and energy companies can easily find a handful of Democrats sympathetic to their views on tax policy.
- Although Not Taxes, Pharma Reimbursements Could Be Included as a Payfor: Democrats have pushed for drug pricing reforms, with the goal of lowering drug pricing costs. One area that can be targeted is the Medicare reimbursement rate for drug companies, by allowing the US government to negotiate the price of drugs or simply lowering the reimbursement rate.
- Some Tax Increases May Be Retroactive: Most tax changes are implemented around the time of enactment. However, there is a possibility that some tax increases could be retroactive. The 1968 and 1993 income tax increases were retroactive. Both passed mid-year and were set back to January 1st. We found no record of capital gains tax increases being retroactive. Estate tax changes in 1993 and 2010 were retroactive, but policymakers warned in advance of changes occurring that year.
Source: Strategas
Sincerely,
Fortem Financial
(760) 206-8500
team@fortemfin.com
