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Monday, April 26, 2010

Democrats Warn Bank Tax Is Coming, "Too Big To Fail"

Max Baucus: A Bank Tax Is Coming

It was a short hallway conversation but spoke volumes about the dilemma facing Democrats, hungry for new revenues after emptying the cupboard on health care reform.

“I don’t think there’s much doubt that there will be a bank tax,” Senate Finance Committee Chairman Max Baucus told POLITICO. And more than ever, the Montana Democrat signaled that Congress will also crack down on wealthy hedge fund and private equity partners who shelter their income as capital gains — taxed at half the top 35 percent rate.

Three times in recent years, the House has voted to rein in the so-called carried interest provision — only to meet Senate resistance. That’s changing with the pressure to find revenues to pay for other priorities such as a $35 billion measure extending popular tax provisions for businesses and families.

“I’ve asked my staff to look at alternatives ... Carried interest will probably be part of the offsets,” said Baucus. “We were thinking of putting it on later as part of tax reform. But we’re here; we’re here now.”

Wealthy Democratic donors are sure to scream; Baucus concedes he could face opposition from his own party moderates. But isn’t the chairman himself the “very soul of the moderate Democrat?” a reporter asks. “I’m a ‘Do-the-Right-Thing’ Democrat,” Baucus grinned.

Doing the right thing isn’t easy in today’s tax-writing world — whipsawed by record deficits, new “pay-go” budget rules, restless voters and a legacy of Bush-era tax breaks due to expire in December. Even the giant financial reform bill, facing its first Senate test Monday night, has potential revenue problems. And Baucus was sorely frustrated last December, when the Senate let the estate tax expire — thereby costing Treasury billions.

At least three major tax-related battles are taking shape in the next few months:

First and most immediate is how to pay for the long-delayed extenders bill, which Democrats want to complete by Memorial Day and which includes a must-pass provision authorizing long-term unemployment benefits past the November elections. Health care picked clean most of the planned revenue offsets in the initial bills, leaving a $35 billion hole and carried interest — worth $24.6 billion over 10 years — standing alone in this game of musical chair offsets.

Second — and fast closing — is President Barack Obama’s proposed bank tax. Baucus wants to keep the bank levy separate from the current debate over financial reform, thereby having the chance to claim the tax revenues as an offset. But the Congressional Budget Office is raising red flags that the Senate reform package will be $17 billion in the red if Democrats drop a $50 billion industry-financed “orderly liquidation fund” opposed by Republicans.

Third, but scarcely least, is this summer’s battle over Bush-era income tax cuts due to expire at the end of this year. The Senate Budget Committee last week approved a five-year plan that assumes the most popular middle-class tax breaks will be made permanent. House Democrats say some extension could be a powerful engine for a revenue bill prior to the elections; part of the mix would be some compromise on the estate tax issue, which splits the party in the Senate.

Each of these fights has its own nuances and competing equities.

The Obama bank tax proposal began as a plan to recoup money already spent by Treasury in the 2008-09 bailouts. The reform bill’s “orderly liquidation fund” is a bet on the future, imposing an assessment on the industry now in case big companies again fail and demand resolution.

Nonetheless, the two issues have become joined in the reform debate. Treasury officials have hinted they would like to sub the bank tax in and the fund out; House Financial Services Committee Chairman Barney Frank (D-Mass.) says Congress should consider a bigger and more permanent bank tax than Treasury has proposed if the liquidation fund is dropped.

“The already strong case for the bank tax gets stronger,” Frank told POLITICO. “I think one possible approach is no pre-existing fund but a bigger and longer-lasting bank tax.”

How the levy is designed depends on how one sees the financial crisis — another reason Baucus is unlikely to move before late May or June, so as to allow time for hearings.

As first proposed in January, the so-called responsibility fee was assumed to raise about $90 billion over 10 years through a 0.15 percent tax on the covered liabilities of the very largest financial institutions. And Treasury has since refined its approach to focus more on risk—measured both by the loans or trading done by banks and how firm the financing is behind them.

In tandem with financial reform the goal is go after what one Treasury official described as “the toxic combination of high levels of risky assets funded by highly unstable sources of funding.”

“We look at both sides of the coin,” he said in an interview. “Someone doing traditional banking — using all deposits to fund even somewhat risky commercial and small-business loans — would be largely shielded from the fee.”

Nonetheless, the mechanics can seem so complicated that this message is lost. And lawmakers are clearly spooked by the notion that the tax could still penalize commercial loans and fall more heavily on banks like Wells Fargo than on Wall Street’s high rollers, Goldman Sachs or Morgan Stanley.

Getting to the bottom of this question means wading into the thicket of Federal Reserve rules governing the weighted risks of commercial loans vs. market activities.

The Fed’s capital experts warn against quick, generalized comparisons, but a Joint Taxation Committee report this month said that “because commercial loans are assigned the highest risk-weight of 100 percent, a tax on risk-based assets could prove a disincentive for an institution to make such loans, including loans to small businesses.”

“There are pluses and minuses,” House Ways and Means Committee Chairman Sander Levin (D-Mich.) told POLITICO. “We’re looking at ways to relate it to risk, but that’s not easy to do because the ‘riskiest’ are commercial loans, and we don’t want to tax those.”

This invites a Ways and Means option based on income and profits. A bank’s taxable income would be first adjusted upward by adding back some portion of the rich bonuses deducted as compensation, then would come a surtax imposed to raise the required funds.

Given the huge profits and bonuses being reported by Wall Street investment banks, this has a clear political appeal. But Treasury would argue that its risk approach is substantively better — in terms of the reform message at home and in partnership with reforms overseas by U.S. allies.

The very different carried interest tax debate has its own nuances — and winners and losers.

At issue is whether income paid to wealthy investment fund managers should be taxed at the 15 percent capital gains rate or the upper income bracket, 35 percent and climbing. Proponents of the current system argue that the managers have a “carried interest” in the capital investments they oversee. Critics say it is ordinary income paid in exchange for the performance of services, and the managers often have very little skin in the capital game.

The House permits some leeway: allowing carried interest to be taxed at the capital gains tax rate to the extent that it reflects a reasonable return on invested capital. And after interviewing different coalitions with a stake in the outcome, Senate Finance staff is now looking at compromises that could address some complaints — but still yield much needed tax revenue.

Hedge fund partners make for an easy political target today, but much of their trading is so short term that it doesn’t qualify for the lower capital gains rate that applies to assets held more than six months.

Private equity, publicly traded partnerships in the energy field and real estate partnerships are often affected more, especially given the strained state of commercial real estate. To win the needed votes, Baucus will have to look at options that ease the transition by perhaps imposing a midpoint rate — between 15 percent and 35 percent — or grandfather in some deals already made before a fixed date.

These deals mean less revenue, so tax writers are also looking at closing a foreign tax credit loophole — estimated to be worth $9.5 billion over 10 years. But the gap is too big to plug without pain.

“There are no easy choices left,” said one person familiar with the search for revenues and focus on carried interest. “No final decisions have been made. We’re about a week away, but I won’t argue, it is a leading candidate.”

Sources: AP, Politico, Youtube

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