For the first time in months, Senate Democrats appear to be making meaningful progress on a potential budget reconciliation package. The scaled-down proposal is expected to include the lowering of prescription drug costs, an extension of Affordable Care Act (ACA) subsidies and funding for climate change initiatives. New spending is likely to be paid for by increases in tax revenue. There is currently an agreement among Democrats to significantly expand the types of passthrough entity income subject to the net investment income tax (NIIT). Negotiations are ongoing, with numerous items yet to be addressed. Our expectation is additional tax provisions will be included in a final agreement.
Sen. Manchin in the driver’s seat
In late 2021, President Joe Biden’s Build Back Better (BBB) agenda came to a standstill when Sen. Joe Manchin (D-W. Va.) announced he would no longer continue to negotiate “this mammoth piece of legislation.” Now, as Democrats revisit the possibility of a smaller reconciliation agreement, Manchin is actively collaborating with Senate Majority Leader Chuck Schumer (D-N.Y.) on a smaller compromise package.
These negotiations have been occurring in piecemeal fashion over the last few weeks. Last week, Democrats finalized a Medicare prescription drug pricing proposal and, as noted above, have agreed upon a framework for the expansion of the NIIT.
While all eyes remain on Manchin, Sen. Kyrsten Sinema (D-Ariz.), a key architect of the final tax provisions included in the 2021 BBB negotiations, is also worth watching. While Sinema hasn’t commented on the latest reconciliation discussions, her support will be essential to the passage of any bill. Specifically, Sinema has consistently been a critic of increasing ordinary income or capital gains tax rates.
What will ultimately be included in any legislation brought to the Senate floor remains unclear; however, it will assuredly be smaller than the sweeping 2021 BBB package. The new package is likely to come in around $1 trillion, per current forecasts. In addition to requiring a smaller scope, Manchin has demanded that 50% of revenue raised by the bill be applied to budget deficit reduction, further constraining the capacity for spending provisions.
Revenue raisers: tax increases
To date, the only agreed-upon tax increase for inclusion in the package is the expansion of the NIIT. Currently, the 3.8% tax only applies to trade or business income from a passthrough entity to the extent it is passive, generally meaning the taxpayer does not materially participate in the trade or business. Under this proposal, the tax would be imposed on all income earned through a passthrough entity, even if the taxpayer actively participates in such business, or the business is the trading of financial instruments or commodities. An exception would be provided for income subject to self-employment taxes. The change would affect taxpayers with income in excess of $400,000 ($500,000 for joint filers, $250,000 for married individuals filing separately) and includes trusts and estates. It is critical to note that the $200 billion in revenue projected to be raised by this provision over 10 years would go to the Hospital Insurance Trust Fund to push its projected insolvency to 2031 from 2028. As such, the funds raised cannot be used to satisfy Manchin’s requirement that half of any revenue raised go toward reducing the deficit.
Additional tax provisions from the 2021 BBB package that could be leveraged as revenue raisers in the current bill include:
At this stage, the featured proposals of the developing framework would enable Medicare to negotiate certain prescription drug prices, cap recipients’ annual out-of-pocket costs at $2,000 and penalize pharmaceutical companies that raise their prices at a faster pace than inflation.
Speculation is that extending the tax credits for ACA premiums, set to expire at the end of the current year, and provisions addressing climate change are the additional spending items most likely to be included in a final bill. However, both face obstacles in acquiring Manchin’s approval. The senator has privately opposed the ACA subsidies, though common ground could possibly be achieved by tying eligibility to the insureds’ income levels. A scaled-back extension of the ACA subsidies is projected to cost approximately $120 billion.
Manchin has also been vocally opposed to the “direct pay” subsidies to producers of clean energy, out of concerns for how they would disadvantage the coal industry which has a substantial presence in his home state of West Virginia. In addition, Manchin has criticized credits for electric vehicles that would benefit high-earners or incentivize the purchase of vehicles produced using unionized labor. Recent estimates of a potential deal on climate spending are in the $300 billion to $350 billion range, down from the $550 billion proposed in the 2021 BBB package.
Path to passage in the Senate
Reconciliation is a special parliamentary procedure used in the Senate to fast-track budgetary legislation. Bills passed via reconciliation are not subject to filibuster rules, requiring solely a simple majority to advance and pass proposed legislation. Because the Senate is currently split 50-50 between Democrats and Republicans, a reconciliation bill will only pass if all Democratic senators vote in favor and will likely require Vice President Kamala Harris to cast a tie-breaking vote.
Sen. Ron Wyden (D-Ore.), chairman of the Senate Finance Committee, seems optimistic, stating, “We’re making real progress, we’re picking up steam … I’m not saying all is done … but I do feel more confident about the progress that has been made.”
Senate Minority Leader Mitch McConnell (R-Ky.) is attempting to derail any potential reconciliation agreement by threatening to hold the bipartisan U.S. Innovation and Competition Act (USICA) hostage. The USICA is a bill that would strengthen the U.S. semiconductor industry to increase chip making in an effort to reduce foreign imports from China. McConnell’s threats indicate real progress is being made on the reconciliation package; however, it may put vulnerable Democrats facing reelection in November in a difficult position. Some Democrats may favor passing USICA before the election and attempting to negotiate and pass a reconciliation package during the upcoming lame-duck session.
Possible trouble in the House
If Senate Democrats reach an agreement on reconciliation, Majority Leader Rep. Nancy Pelosi (D-Calif.) will need to address a looming issue in the House. A block of representatives, the State and Local Tax (SALT) Caucus, has publicly threatened to not vote for any reconciliation bill that does not include a repeal or reform of the TCJA-enacted $10,000 SALT deduction cap. Further complicating matters is the possibility that the House’s Progressive Caucus will not support a bill scaled back from BBB, which already represented a significant reduction of the scope of Biden’s social agenda they hoped to accomplish. Given the thin majority they hold in the lower chamber, Democrats can afford few defections en route to passage of any legislation.
Schumer and the White House would like to have a bill on the floor before the Senate leaves for its August recess, which begins Aug. 6. This was viewed by many as an aggressive timeline even before Schumer announced he tested positive for COVID-19 on July 11. Although, there have been rumors that Schumer may delay the recess in order to move this legislation forward.
Ultimately, Congress has until Sept. 30 to pass a reconciliation package. After that, the fiscal year 2022 budget and reconciliation instructions expire; in order to pass a bill via reconciliation after this date, Congress would need to adopt a new budget resolution. In addition, Congress is scheduled to adjourn Oct. 1 in order to campaign for the upcoming midterm elections.
Please reach out to your Baker Tilly advisor if you have questions regarding your tax position. We will continue to monitor developments on the situation and issue additional alerts as warranted.
We encourage you to connect with your Baker Tilly advisor regarding how the above may affect your tax situation.
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