The Treasury recently released a general explanation of the revenue proposals in President Obama’s budget for 2014. In an attempt to broker a deal between Republicans and Democrats, President Obama’s budget proposals include both spending cuts and tax hikes.
Cuts to Social Security Benefits
President’s budget would cut Social Security by changing the index used to calculate inflation adjustments, including increases in Social Security payments. The current inflation-adjustment formula is based on the CPI for all Urban Consumers (CPI-U). The CPI-U is an index that measures prices paid by typical urban consumers on a broad range of products. According to the Treasury:
The CPI-U typically overstates the effects of inflation because it does not fully reflect changes in consumption patterns in response to relative price changes. The chained CPI-U (C-CPI-U) would account more fully for this substitution effect and therefore better reflect changes in the cost of living.
The President wants to ditch the CPI-U in favor of the C-CPI-U. Economists agree that a chained CPI is a more accurate measure of how people spend when prices rise. But adopting the C-CPI-U will lower the inflation rate that is used to calculate cost-of-living increases for Social Security recipients. These lower inflation adjustments for Social Security benefits will effectively reduce future payments to Social Security recipients.
Thirty Percent Minimum Tax on Millionaires
The President would impose a new minimum tax, called the Fair Share Tax (FST), on high earners. The FST targets itemized deductions, which disproportionately benefit high-income taxpayers. These deductions, coupled with preferential capital gains rates, can give high-income taxpayers a lower average tax rate than a lower-income, wage-earning taxpayer. The President believes that restricting deductibility with an across-the-board minimum tax would make the tax system more progressive and distribute the cost of government more fairly among taxpayers.
The tentative FST equals 30 percent of AGI, less a credit for 28 percent of charitable gifts. The FST would be phased in linearly starting at $1 million of AGI ($500,000 in the case of a married individual filing a separate return). The FST is fully phased in at $2 million of AGI ($1 million in the case of a married individual filing a separate return).
Restrictions on Itemized Deductions that Exceed 20 Percent of AGI
Under current law, individual taxpayers can choose to itemize their deductions instead of claiming the standard deduction (currently $6,100 for individuals and $12,200 for married taxpayers filing jointly). Common itemized deductions include:
- Medical and dental expenses that exceed 10 percent of AGI (7.5 percent for taxpayers over age 65);
- State and local property and income taxes; and
- Gifts to charities.
In addition to itemized deductions, taxpayers can reduce their income by excluding certain types of income and claiming certain deductions in the computation of AGI (“above the line” deductions).
The administration believes that limiting these deductions will help close the tax gap. The President’s budget proposal would limit the tax value of certain deductions and exclusions from AGI and all itemized deductions for taxpayers in tax brackets that are 33 percent and above. That would hit individuals with income over $185,000 ($225,000 for married couples).
This new restriction would affect items that have generally considered tax-free. For example, the new rule would effectively impose a tax of up to 11.6 percent for tax-exempt interest and the value of employer-provided health insurance. Other targets include health insurance costs of self-employed individuals, interest on education loans, employee contributions to defined contribution retirement plans and IRAs, contributions to HSAs and Archer MSAs, and higher education expenses.
Restrictions on Contributions to Large Retirement Plans
Current law limits contributions to and benefits paid from different types of retirement plans. For 2013:
- The maximum amount permitted to be paid under a qualified defined benefit plan is $205,000 annually;
- The maximum annual contribution to a defined contribution plan is $51,000, with a separate $17,500 elective deferral limit;
- The maximum annual contribution to an individual retirement account or annuity (IRA) is $5,500, with an additional $1,000 for taxpayers who are over age 50.
The annual contribution limit for IRAs is applied by aggregating all of the taxpayer’s IRAs. But the limitation on accruals from defined benefit plans and the limitation on contributions are generally not aggregated. This effectively allows taxpayers with multiple plans established by different employers to exceed the limits.
The Obama administration believes that the current rules do not adequately limit the extent to which a taxpayer can accumulate amounts through the use of multiple plans. Under the proposed 2014 budget, taxpayers could make no further contributions or receive additional accruals from tax-favored retirement accounts that exceed the amount necessary to provide the maximum annuity permitted for a tax-free defined benefit plan under current law (the $205,000 limitation mentioned above).
In other words, under the President’s budget proposal, individuals with total retirement plan assets that exceed the threshold amount could no longer make tax-favored contributions to their retirement plans. The threshold is based on the present value of a $205,000 for a 62-year-old (currently $3.4 million). Although the existing balance in the accounts could continue to grow, no additional contributions would be permitted. If enacted, this proposal would effectively curtail the use of tax-favored retirement planning for wealthy individuals.
Loosening of Distribution Rules for Modest Retirement Plans
Under current law, the required minimum distribution (RMD) rules require participants in tax-favored retirement plans to start drawing distributions after reaching age 70½. The purpose of these rules is to prevent taxpayers from stretching the tax deferral by over-funding retirement and not withdrawing funds, leaving the accounts to accumulate tax-free for estate planning purposes.
The President’s budget recognizes that the RMD rules affect millions of senior citizens with only modest tax-favored retirement accounts. The budget explanation states that taxpayers with small retirement accounts are less likely to be motivated by estate planning purposes to leave funds to accumulate tax-free for the benefit of the next generation. Under the President’s budget proposal, taxpayers with less than $75,000 in tax-favored retirement accounts would not be subject to the RMD rules.
Republican Response to the President’s 2014 Budget
As to be expected, top Republicans are less than enthusiastic about President Obama’s proposals. Senate Republican Leader Mitch McConnell has already called it “just another left-wing wish list” that “does not represent some grand pivot from left to center. It’s really just a pivot from left – to left.”
But some Republicans have also given a nod of approval to the President for at least proposing spending cuts. House Speaker John Boehner stated:
While the president has backtracked on some of his entitlement reforms that were in conversations that we had a year and a half ago, he does deserve some credit for some incremental entitlement reforms that he has outlined in his budget. But I would hope that he not hold hostage these modest reforms for his demand for bigger tax hikes.
To call this a measure of bipartisan support, though, would be unrealistic. It is likely that this budget will—like the President’s prior budgets—end up as a position statement with no real chance of becoming law. The continuing lack of bipartisan solutions signals a difficult road to tax reform.