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09/05/2017

How Tax Reform Could Lead to Sequestration (article)


The procedural requirements of the Senate’s Budget Reconciliation rules continue to reign supreme in the shaping of tax reform. Our previous article focused in part on how deficit neutrality beyond a 10-year budget window could make tax reform more difficult or, as recent headlines reflect, push Congress and the Administration towards temporary tax cuts. However, these rules are not the only source of budgetary concerns along the road to tax reform or temporary cuts. In 2010, Congress re-enacted a statute known as the Pay-As-You-Go Act (PAYGO). The purpose of PAYGO is to limit the capacity for spending or tax cut measures in order to prevent increases to the deficit. The Senate has similar rules, but those will not be explored further since the Senate can bypass its similar rules under a simple majority vote (which was done as part of the previous attempts at health care reform).

What is PAYGO?

PAYGO can be understood as requiring mandatory spending cuts (sequestration) when new legislation otherwise increases spending or reduces revenue. It is important to remember that PAYGO only applies to new legislation; deficits created by legislation passed in previous years are not considered.  This becomes relevant as multi-year legislation is measured against the annual application of PAYGO. Equally important is the scope of PAYGO. A bill passed under Budget Reconciliation rules can’t increase the deficit outside of a 10-year window. However, the PAYGO rules are more expansive. They consider all of the legislation passed during the year, including budget reconciliation legislation.

For example, if Congress uses Budget Reconciliation rules to pass a temporary tax cut, it could do so by having some or all of the cuts expire within the 10-year budget window to create a set of cuts that would be contained to that period. However, if the tax cuts are extensive enough, then it becomes necessary to supplement those cuts with new revenue near the end of the window. A hypothetical example could be a reduction of the corporate tax rate by 15 percent for the first seven years, paired with an increase to the corporate tax rate by 25 percent for the remaining three years, thereby offsetting the early cuts with a tax increase. And as long as the combined revenue losses and revenue gains from the respective tax cuts and tax increases do not result in an increase to the deficit outside of the 10-year window, the legislation could still be passed using reconciliation. PAYGO, on the other hand, operates differently.

PAYGO & Sequestration

First, PAYGO is applicable on an annual basis. This means that legislation covered by PAYGO may not increase the deficit in any given year. Second, PAYGO considers (nearly) all legislation passed during the year cumulatively. In the instance of tax reform, a tax cut would be combined with other mandatory spending measures to determine if it was deficit neutral in a given year. Discretionary spending, which is allocated via appropriation bills, is not considered under PAYGO when determining whether spending during the year is deficit-neutral. If the score from PAYGO legislation for a given year is found to have violated the anti-deficit rules, the mandatory cuts under sequestration begin.

These cuts can affect areas such as Medicare (subject to a 4 percent cap on Medicare cuts), The National Flood Insurance Fund’s administrative expenses, the Assets Forfeiture Fund, U.S. Citizenship and Immigration Services, and U.S. Custom and Border Patrol, among other government agencies and programs. The amount that can be sequestered in fiscal year 2018 is approximately $103 billion dollars, with $26 billion of that coming from Medicare. In fact, these mandatory PAYGO cuts are more aptly described as automatic, since the cuts will go into place at the end of the fiscal year unless Congress takes action to prevent the cuts.

Because the cuts apply at the end of the fiscal year and not necessarily at the moment legislation is passed, Congress has time to negotiate a PAYGO-compliant solution. It can pass legislation that removes spending measures from the cumulative cost of the legislation passed during the year. Or it can go even further and pass a bill that zeroes out the equation entirely—essentially  ignoring the PAYGO rules—which was done in 2001 for the Bush tax cut. However, these measures are subject to a filibuster in the Senate. Presently, this could create unusual divisions given that the interests of anti-deficit conservatives could be paired together with liberals who are expected to oppose the tax cuts.

Dynamic Scoring can also affect the impact of the PAYGO rules. When determining whether tax cuts result in a cumulative deficit increase, Dynamic Scoring could implicate projected economic growth (and attendant increases to tax revenues) as an indirect result from legislation, to offset the budgetary effects to the deficit. However, this would probably require an aggressive projection of growth. As stated earlier, PAYGO is applied on a year-by-year basis and not over a set 10-year stretch. This means that if Congress passed a tax cut for the current fiscal year subject to PAYGO, it would need to project immediate growth under Dynamic Scoring as a result of the cut so as to offset the revenue losses from the cut. Economic growth that is projected to start in year one is not generally supported by economists, or by the current Administration, and is an assumption that is considerably more aggressive than what could be used to score legislation under Budget Reconciliation rules.

Overall, the PAYGO rules represent a significant budgetary consideration that legislators must consider, together with the Budget Reconciliation rules, in order to make tax reform a reality. For more information on the PAYGO rules and tax reform in general, please contact your local CBIZ tax professional.


Copyright © 2017, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

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