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

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.