Budget Deal Gives New Tax Cut to Wealthy – And Pretends It’s a Tax Increase

January 2, 2013 at 6:29 pm

The new budget deal delays the across-the-board spending cuts (or “sequestration”) for two months — and covers half of the resulting $24 billion cost through spending cuts and half through tax increases.  This 50-50 balance between spending cuts and revenue increases marks an important principle that policymakers should follow in producing the additional long-term deficit reduction that the nation needs.  Unfortunately, while the spending cuts in question are real, the tax increase isn’t.  It’s fake.

Actually, it’s worse than fake — it’s a new tax cut, primarily for affluent households, that’s being portrayed as a tax increase.  It uses a timing gimmick to raise $12 billion in revenue over the next ten years.  But every dollar of that $12 billion is revenue that the federal Treasury would have collected in subsequent decades.  And, the resulting revenue loss in later decades will be substantially greater than $12 billion — probably several times that amount.

That also suggests that the White House’s crucial call for a dollar in revenues for each dollar in spending cuts in a budget package later this winter that would presumably replace sequestration and raise the debt limit — an essential condition for a balanced package — is not off to a promising start.  To get a Joint Tax Committee “score” of $12 billion in new revenue over the next ten years, Republican negotiators crafted a new tax break that slightly worsens long-term fiscal imbalances and ultimately reduces revenue rather than increasing it.

Here’s the issue.  Under current law, amounts deposited in employer-sponsored retirement accounts like 401(k)s and 403(b)s are exempt from income tax when the deposits are made, while the withdrawals in retirement are taxable.  Some employers offer plans that include not only a 401(k) or similar type of account but also accounts, known as “Roth” accounts, in which contributions are taxed up front while the withdrawals in retirement are tax free.  Currently, taxpayers can shift money from the 401(k)-like parts of their plan into a Roth account only in very limited circumstances — generally, only with money that they’ve paid out of their 401(k) because they have reached the age of 59½ or have left the employer.

The new provision would let these individuals decide, at any time, to shift large sums (even their entire balances) from 401(k)s, 403(b)s and the like to a Roth account.  They would have to pay tax on the amounts that they shifted, but all subsequent earnings on the Roth accounts — and all withdrawals in later years — would be tax free.  People who calculated that this would maximize their tax break and minimize their tax payments over time would make the shift.  People who didn’t think they would get a bigger tax cut wouldn’t.

This maneuver raises money for the Treasury in the early years, because people making the shift would pay income tax on the amounts that they moved to the Roth accounts, while the corresponding revenue losses would largely occur beyond the 10-year “budget window.”  But people would do so only if they would pay less tax over time.  The long-run effect would be a significant revenue loss.

As the Wall Street Journal put it yesterday, “In effect, the move provides more up-front revenue to the Treasury, but potentially at the cost of revenue over the long term — as taxes paid when individuals make withdrawals from their 401(k) plans would likely be far greater.”

So, here’s the bottom line: this isn’t a tax increase to offset half of the cost of delaying the sequestration.  It’s another tax cut masquerading as one.

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More About Robert Greenstein

Robert Greenstein

Greenstein is the founder and President of the Center on Budget and Policy Priorities. You can follow him on Twitter @GreensteinCBPP.

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6 Comments Add Yours ↓

Comments are listed in reverse chronological order.

  1. Paulette A. Meulenberg #

    Who are the “Republicans” or congressmen that came up with this clever “tax increase?”

  2. Guy Bloomfield #

    Roth IRAs deductions are phased out for people with incomes greather than 188K aren’t they? So if this is a tax cut in disguise it’s not for the wealthy.

    • CBPP #

      Thanks for your comment. The provision of the fiscal cliff deal discussed in this blog post relates to Roth 401(k)s (employer-sponsored retirement plans), which are not subject to the same income limits as Roth IRAs.

  3. 4

    Doesn’t this blog ignore the favorable early impact of the federal revenue collected by taxes paid at the time of converting the 401(k) or 403(k) to a Roth IRA? The author appears to only address the lost long run revenue foregone due the short term revenue gain Yet, the author ignores the benefit accrued by the short term revenue gain of reducing future interest obligations by paying down the debt. Am I the only one who sees the apparent bias of the authors perspective? (And if that money doesn’t go to pay down the debt, than we need only look at who is controlling the purse strings in congress)

    Furthermore, people who convert to Roth IRA’s would pay taxes at the higher tax rate of their current tax liability status compared to the lower tax rate associated with a retirement tax liability status. This also translates to more “Roth IRA” govt revenue dollars than the a long run govt revenue dollars expected if the tax were paid at retirement via the 401(k) or 403(k) vehicle.

    Seems like the important message in this blog is to plant the seed that something nefarious was done thereby further undermining the people’s confidence in their political leaders. Perfect strategy to suppress voter turnout in 2014 – Instill Voter Apathy. Furthermore, it is another strategy to divide the people and turn them away from those who are trying to reverse the economic transfer of wealth to the already wealthy. They rely on the fact that the average person has no idea of how to critically analyze their writings and will assume the article’s conclusion must be true. Unfortunately, it is quite apparent that some people will say and do anything for their own personal gain, as evidenced by the recent presidential election, and do so without ANY sense of consciousness or morality.

    Thanks for sharing the article and allow others to speak to the topic. I suspect an accountant could ferret out the nuance of the “long run, short run govt revenue difference”. But clearly, the articles conclusion is far from concrete, despite the fact they want you to believe otherwise.

    • msf #

      Addressing the issues raised in order:

      – The interest rate on the federal debt is extraordinarily low. It is thus reasonable to assume that 401K performance (at least on average, across all individuals) will outperform the rate of interest on the debt. Actually, since 401K’s are mixes of stocks and bonds, and over the long term that mix outperforms a pure bond portfolio, it is reasonable to assume that the 401Ks will outperform the interest rate on the debt, whatever that rate rises to.

      Thus Mr. Greenstein is correct in asserting that Roth conversions (whether in a 401K or an IRA) deprive the IRS of income, even after the time value of money (interest on the debt) is incorporated.

      – Some people will have significantly lower marginal tax rates in retirement(even after considering the effect of income on the taxation of social security benefits). Those people will not convert, as Mr. Greenstein makes clear: “People who didn’t think they would get a bigger tax cut wouldn’t [convert].” So this is a one-sided deal – heads the taxpayer wins, tails the IRS loses.

      More important is that the winners, the people most likely to benefit from the conversion, are the wealthy. This is because they’re the ones most likely to not see their tax brackets drop in retirement. They’re the ones with the golden parachutes, the consulting gigs, etc. that will keep their ordinary income up.

      Opening up IRA conversions to everyone was a gift to the affluent; this is another.

    • Beeker #

      While you make the argument that Mr Greenstein ignored the favorable impact of early at the time of conversion to a Roth IRA, however according to the CBO and the JCT, it does show the loss of revenue in the long run (which is 10 years) because it is foregone revenue. You make the argument that people who convert now will pay a higher tax than at retirement which result in more “Roth IRA” government revenue is a misleading misnomer because the federal government does not piece out the impact of revenue based on individual IRA conversion because it is including other taxes into the equation which makes it all impractical. You are making a similar statement that conservatives make when they stated that Reagan tax cut resulted in more revenue to the government when it is a loss of revenue, period. Even David Stockman, once a supply sider, admit he does not embrace that philosophy.

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