Budget Control Act of 2011:

September 7, 2011 Budget Control Act of 2011: Where do we go from here? Washington Council Ernst & Young Ernst & Young LLP President Obama signed the Budget Control Act of 2011 ( BCA, P.L. 112-25) on August 2, 2011, hours before the deadline by which Treasury Secretary Geithner said the Treasury Department would no longer be able to pay all of the nation s obligations. The law provides for a three-step process to raise the federal debt limit by as much as $2.4 trillion, satisfying President Obama s priority of increasing the debt limit by a sufficient amount to maintain government operations at least through the 2012 elections. The BCA reinstates statutory caps on discretionary spending, requires a vote on a balanced budget amendment to the US Constitution, and created the Joint Select Committee on Deficit Reduction ( Joint Select Committee ), a bipartisan, bicameral panel of 12 members with a goal of developing legislation by November 23, 2011, to reduce the federal deficit by $1.5 trillion. This article addresses: 1. The mechanics of the debt limit increase under the BCA 2. The functions of the Joint Select Committee 3. The process for enforcing discretionary spending caps established by the law 4. Implications for tax and health care policy under the BCA 5. Recent tax and health care reform proposals

Three-step process to raise the debt limit The Budget Control Act of 2011 establishes a three-step process to increase the federal debt limit by as much as $2.4 trillion provided that the deficit is reduced by an amount greater than the increase in the debt limit. Step 1: Upon certification by the President that the debt subject to the limit is within $100 billion of the limit, the debt limit is raised by $400 billion immediately. President Obama made this certification on August 2, shortly after signing the BCA into law, and the debt limit was raised accordingly. Step 2: The debt ceiling will be increased by an additional $500 billion by September 21, 2011, (50 calendar days after the certification) unless Congress enacts a joint resolution of disapproval, which would be subject to a presidential veto. A vote by two-thirds of both the House and Senate would be required to overturn the veto. Given the makeup of Congress, it is highly unlikely that an increase to the debt limit will be blocked. Step 3: Following the increase of the debt limit by the first $900 billion, the President again may certify that the debt subject to the limit is within $100 billion of the limit and that further borrowing is required to meet existing commitments. Upon receipt of the certification, Congress will have 15 days to enact a joint resolution of disapproval (which again is subject to a presidential veto). The debt limit could be increased by $1.2 trillion to $1.5 trillion in this third tranche if a deficit reduction plan is reported by the Joint Select Committee on a majority vote, passed by Congress and signed into law. Alternatively, the debt limit could be increased if Congress approves a resolution proposing a balanced budget amendment to the Constitution. The expected increase of at least $2.1 trillion in the debt limit is projected to be sufficient to maintain government operations through at least the 2012 elections. The diagram below provides an overview of the process for raising the debt limit and the corresponding mechanisms for reducing the deficit. Step 1 Step 2 Step 3 The debt limit is increased by $400 billion immediately upon the President s certification that debt is within $100 billion of the limit. The debt limit will be increased by $500 billion by Sept. 21, 2011, unless Congress enacts a joint resolution of disapproval and overrides a likely presidential veto. The debt limit could be increased by between $1.2 trillion and $1.5 trillion depending upon enactment of legislation proposed by the Joint Select Committee or approval of a balanced budget amendment. The President s request for a third increase to the debt limit also could be blocked if Congress approves a joint resolution of disapproval and overrides a veto. The $900 billion increase to the debt limit included in the first two steps of the process created by the BCA will be offset by $917 billion in deficit reduction achieved through spending reductions resulting from 1) statutory caps on discretionary spending for fiscal years 2012 2021, 2) lower mandatory spending as a result of increased program integrity and changes to some education programs, and 3) lower debt service payments. The third increase to the debt limit would be offset by: 1) Initiatives that would reduce the deficit by $1.2 trillion $1.5 trillion as specified in legislation by the Joint Select Committee; 2) Automatic spending reductions amounting to $1.2 trillion if deficit reduction legislation by the Joint Select Committee is not enacted; or 3) Savings achieved through a balanced budget amendment. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 2

Elements of the BCA Spending caps. Statutory limits on discretionary spending extended by the Budget Control Act of 2011 account for $756 billion of the $917 billion in deficit reduction over fiscal years 2012-2021 that the Congressional Budget Office ( CBO ) attributes to provisions of the BCA apart from those related to the Joint Select Committee. Lower mandatory spending as a result of increased program integrity spending (i.e., activities that are intended to produce a net reduction in federal spending) and changes to some education programs, and lower debt service payments (interest on federal debt) comprise the remaining $161 billion in deficit reduction. The statutory limits on discretionary spending initially were created by the Balanced Budget and Emergency Deficit Control Act of 1985 ( Gramm-Rudman-Hollings ). The limits were extended in 1993 and 1997 but expired in 2002. For fiscal years 2012 and 2013, the law creates separate caps for security and non-security spending. One cap for all discretionary spending will apply beginning in fiscal year 2014. The caps will not apply to spending for the wars in Afghanistan and Iraq, overseas contingency operations, or certain amounts of increased federal spending for two program integrity initiatives detailed below. 1. The BCA permits discretionary spending caps for the Social Security Administration s program integrity activities to be increased by $3.9 billion over 10 years above the March 2011 CBO baseline. The CBO estimates that this increased program integrity spending will reduce benefit outlays for disability insurance, Supplemental Security Insurance, Medicare and Medicaid by about $11.872 billion over 10 years and that additional savings will accrue after 2021. 2. The law permits discretionary spending caps for the Health Care Fraud and Abuse Control Account (HCFAC) to be increased by $2.967 billion over 10 years above the March 2011 CBO baseline. (HCFAC supports activities to reduce fraud, waste and abuse in Medicare, Medicaid and the Children s Health Insurance Program ( CHIP ).) The CBO estimates that this increased program integrity spending will reduce benefit outlays for Medicare, Medicaid and CHIP by about $3.741 billion over 10 years and that additional savings will accrue after 2021. The BCA also permits adjustments to the caps in each fiscal year to account for funding for emergency requirements and disaster relief. A chart summarizing the annual discretionary spending caps and the corresponding reduction from the CBO current law baseline is provided below. Balanced budget amendment. The BCA states that the House and Senate shall vote on passage of a balanced budget amendment to the Constitution between September 30, 2011, and December 31, 2011. The law neither requires the Senate and the House to vote on the same constitutional amendment nor does it impose any procedural consequence if either the House or Senate does not vote on a balanced budget amendment. Not approving a balanced budget amendment would simply eliminate one option under the BCA for increasing the debt limit by $1.5 trillion. There likely is sufficient support among House Republicans to reach the two-thirds majority threshold needed to win approval in that chamber. However, the proposal likely will fall short in the Senate where many Democrats oppose it, and a vote on the proposed constitutional amendment could be blocked easily through procedural maneuvers. Joint Select Committee. The BCA established a 12-member Joint Select Committee on Deficit Reduction, with the Majority and Minority leadership of both the House and the Senate each appointing three members. The law created the Committee with a goal of reducing the deficit by $1.5 trillion in fiscal years 2012 2021. Sen. Patty Murray (D-WA) and Congressman Jeb Hensarling (R-TX) are the Committee s co-chairpersons. Other members of the committee are Sens. Max Baucus (D-MT), John Kerry (D-MA), Jon Kyl (R-AZ), Rob Portman (R-OH), and Pat Toomey (R-PA) and Congressmen Dave Camp (R-MI), Fred Upton (R-MI), Jim Clyburn (D-SC), Xavier Becerra (D-CA) and Chris Van Hollen (D-MD). Notably, both chairmen of the tax-writing committees Baucus (Finance) and Camp (Ways and Means) were appointed to the Joint Select Committee, and four members (Baucus, Hensarling, Camp and Becerra) who served on President Obama s National Commission on Fiscal Responsibility and Reform ( Bowles-Simpson Commission ) also were appointed to the Committee. No member of the so-called Senate Gang of Six was appointed to the Committee. In addition, all Republican members of the Committee have signed Americans for Tax Reform s ( ATR ) Taxpayer Protection Pledge, which ATR describes as a commitment candidates and incumbents make to oppose any and all tax increases. Additional details on the Committee members are provided in the charts on pages four and five. Proposed discretionary spending caps and corresponding reductions from the CBO baseline (billions of dollars) 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 $1,241 (-$25) $1,170 (-$47) $1,148 (-$59) $1,149 (-$67) $1,164 (-$74) $1,179 (-$81) $1,196 (-$89) $1,226 (-$97) $1,252 (-$104) $1,278 (-$112) Source: Congressional Budget Office, August 1, 2011 Budget Control Act of 2011 Analysis Washington Council Ernst & Young 3

Joint Select Committee membership Senate Sen. Patty Murray (D-WA), co-chair Sen. Max Baucus (D-MT) Sen. Murray is Secretary of the Democratic Conference and Chairwoman of the Democratic Senatorial Campaign Committee. She is a senior member of the Senate Budget Committee and also sits on the Appropriations; Health, Education, Labor and Pensions; Veterans Affairs; and Rules and Administration committees. Sen. Murray was elected to the Senate in 1992. Sen. Baucus is Chairman of the Senate Finance Committee (which has jurisdiction over tax issues, Medicare, Medicaid and Social Security) and the Joint Committee on Taxation. He also sits on the Agriculture and Environment and Public Works committees. As a member of the Bowles-Simpson Commission, Sen. Baucus voted against approval of the Commission s final report in part because of the report s recommendations to expedite implementation of delivery system reforms included in the Patient Protection and Affordable Care Act of 2010 ( PPACA ) and proposed changes to Medicare and Medicaid. Baucus also participated in deficit reduction negotiations led by Vice President Biden earlier this year. Baucus was elected to the Senate in 1978 after serving two terms in the House of Representatives. Sen. John Kerry (D-MA) Sen. Jon Kyl (R-AZ) Sen. Kerry is Chairman of the Senate Foreign Relations Committee, and he also serves on the Finance; Small Business and Entrepreneurship; and Commerce, Science and Transportation committees. He was elected to the Senate in 1984 and was the Democratic nominee for president in 2004. Sen. Kyl is the Senate Republican Whip and a member of the Finance and Judiciary committees. He participated in Vice President Biden s deficit reduction negotiations. After serving four terms in the House, Sen. Kyl was first elected to the Senate in 1994. He is not seeking re-election in 2012. Sen. Rob Portman (R-OH) Sen. Pat Toomey (R-PA) Sen. Portman sits on the Budget, Armed Services, Energy and Natural Resources, and Homeland Security and Governmental Affairs committees. He was elected to the Senate in 2010. During the administration of President George W. Bush, Portman served as US Trade Representative from 2005 to 2006 and Director of the Office of Management and Budget from 2006 to 2007. Portman served in the House from 1993 until 2006 when he was nominated as Trade Representative. Portman was a member of the House Ways and Means and Budget committees. Sen. Toomey serves on the Budget; Banking, Commerce, Science and Transportation; and Joint Economic committees. Earlier this year, Sen. Toomey offered a budget proposal that sought to balance the budget within 10 years; the legislation would have converted Medicaid to a block-grant program, but it would not have made major changes to Medicare. The proposal was rejected in May. Sen. Toomey voted against the Budget Control Act, saying that the law does nothing to deal with the path of our government s unsustainable deficit spending and will permit the debt to continue to grow. He was elected to the Senate in 2010 and served three terms in the House from 1999 to 2004. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 4

Joint Select Committee membership House Rep. Jeb Hensarling (R-TX), co-chair Rep. Hensarling is Chairman of the Republican Conference and is a former Chairman of the Republican Study Committee. Hensarling is Vice Chairman of the Financial Services Committee. He was a member of the Bowles-Simpson Commission and voted against approval of the Commission s report. In his statement explaining that vote, he said the proposal calls for a massive tax increase on the American people without fundamentally addressing the largest, long-term driver of our nation s debt crisis rising health care costs. Rep. Hensarling was first elected to the House in 2002. Rep. Dave Camp (R-MI) Rep. Camp is Chairman of the Ways and Means Committee, which has jurisdiction over tax, tariff and trade laws, as well as Medicare and Social Security. Camp explained his vote against approval of the Bowles-Simpson Commission s final report by saying that the proposal would have increased taxes to cover higher spending and that it did not address increased health care spending resulting from PPACA. Rep. Camp was first elected to Congress in 1990. Rep. Fred Upton (R-MI) Rep. Jim Clyburn (D-SC) Rep. Upton is Chairman of the Energy & Commerce Committee, which has jurisdiction over issues including Medicaid, Medicare, telecommunications, environmental quality, the availability of affordable energy, and interstate and foreign commerce. Rep. Upton was first elected to Congress in 1986. Rep. Clyburn is Assistant Democratic Leader and is a former House Majority Whip, Chairman of the Democratic Caucus, and Chairman of the Congressional Black Caucus. Clyburn participated in deficit reduction efforts led by Vice President Biden. He was first elected to the House in 1992. Rep. Xavier Becerra (D-CA) Rep. Becerra is Vice-Chair of the Democratic Caucus and is a member of the Ways and Means and Budget committees. He voted against approval of the Bowles- Simpson Commission s final report, explaining that the report did not do enough to address jobs or go far enough on tax reform. Rep. Becerra also voted against the Budget Control Act, explaining that the law is not balanced, does not address a lack of jobs in the US, and does nothing about the main drivers of our deficits: the Bush tax cuts, and the unfunded wars in Iraq and Afghanistan. Rep. Becerra was first elected to Congress in 1992. Rep. Chris Van Hollen (D-MD) Rep. Van Hollen is Ranking Democrat on the House Budget Committee. He participated in Vice President Biden s negotiations on deficit reduction. He was first elected to Congress in 2002. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 5

Joint Select Committee actions The Committee members will work on a very tight schedule as their final recommendations from the Committee are due by November 23, 2011. Committee Co-Chairpersons Murray and Hensarling on August 23 issued a joint statement saying that they are engaging in serious discussions to determine what set of rules will govern the committee s operation, examining a schedule of potential meetings and exploring how to build a committee staff that will help us achieve success. The statement added that most of the committee members are reviewing the deficit reduction work that many others have engaged in over the past several years. Murray and Hensarling one week later announced that Mark Prater, deputy staff director and chief tax counsel to Senate Finance Committee Ranking Republican Sen. Orrin Hatch (R-UT), will serve as staff director of the Joint Select Committee. On Sept. 6, Murray and Hensarling announced that the Committee s deputy staff director will be Sarah Kuehl, a senior budget analyst for the Senate Budget Committee Democratic staff who handles Medicare, health insurance, and Social Security. Under the BCA, House and Senate committees may submit recommendations for changes in law to reduce the deficit to the Joint Select Committee by October 14, 2011. The Joint Select Committee is not required to act on the recommendations. Under the BCA, the Committee is required to vote by November 23, 2011, on: 1. A report that includes a detailed statement of findings, conclusions and recommendations of the Committee, including the Congressional Budget Office s estimate of the recommendations; and 2. Legislative language to carry out the Committee s recommendations. Passage would require a simple majority vote by the Committee (seven of 12 members). Any recommendations approved by the Committee would be submitted to the White House and congressional leaders and then sent to the Senate and House of Representatives for a vote. Amendments to the legislation are not permitted, and a filibuster in the Senate also is prohibited. The Senate and House are required to vote on the Committee s recommendations by December 23, 2011. An automatic process to reduce spending, including sequestration, would be triggered if a law that would reduce the deficit by at least $1.2 trillion over 10 years is not enacted by January 15, 2012. Sequestration of funds would occur on January 2, 2013. Other key dates in the time frame of the law are highlighted in the chart below. Timeline of action under the Budget Control Act of 2011 Time frame for consideration of balanced budget amendment in Congress September 30 December 31, 2011 Deadline for House and Senate committees to submit recommendations to the Joint Select Committee Deadline for Joint Select Committee to vote on a report and legislative recommendations Deadline for Joint Select Committee report and legislative language to be submitted to the White House and congressional leaders Bill must be introduced in House and Senate the next day those chambers are in session after the bill is submitted to the White House and Congress Deadline for any committee of the House and Senate to which the Joint Select Committee bill is referred to report it out without amendment October 14, 2011 November 23, 2011 December 2, 2011 December 3, 2011 December 9, 2011 Deadline for vote on Joint Select Committee bill in House and Senate December 23, 2011 Date by which bill must be enacted in order to avoid trigger of sequestration January 15, 2012 Joint Select Committee terminates January 31, 2012 Date on which sequestration for Fiscal Year 2013 would occur January 2, 2013 Budget Control Act of 2011 Analysis Washington Council Ernst & Young 6

Budget goal enforcement: Sequestration trigger The BCA establishes an automatic process to reduce spending beginning in fiscal year 2013 if Joint Select Committee legislation that reduces the deficit by at least $1.2 trillion over FY 2012-2021 is not enacted. If legislation is enacted that reduces the deficit by any amount less than $1.2 trillion, spending reductions would be triggered totaling the difference between $1.2 trillion and the amount of deficit reduction achieved by the enacted legislation. The BCA would achieve the spending reductions through a combination of: 1) The sequestration process first established by Gramm- Rudman-Hollings in 1985 and subsequently modified, including by the 2010 Statutory PAYGO Act; and 2) A downward adjustment of revised discretionary spending limits. It is important to note the distinction between the BCA s strategies for enforcing the law s budget goals, sequestration and the adjustment of revised discretionary spending limits. The Congressional Research Service defines sequestration as the largely across-the-board cancellation of budgetary resources (i.e., spending cuts) in nonexempt accounts and notes that budgetary resources include new budget authority, unobligated balances and obligation limitations. By comparison, the downward adjustment of revised discretionary spending limits lowers the discretionary spending limits established in the BCA; Congress and the President would maintain a strong role in determining how to implement the prescribed spending reductions. As noted above, sequestration applies only to nonexempt accounts. As amended by the 2010 Statutory PAYGO Act, the list of programs and activities exempt from sequestration includes refundable income tax credits, Social Security, Medicaid, CHIP, and other programs for lowincome people and economic recovery. Congress and the President could modify or terminate the budget goal enforcement process by passing a law altering the BCA, possibly as part of legislation by the Joint Select Committee. Because sequestration and other spending cuts would not take place until 2013, a law to sidestep the budget goal enforcement process also could be enacted sometime in 2012. Calculating the automatic spending reductions. In the event that a bill is enacted that does not reduce the deficit by at least $1.2 trillion, the BCA directs the White House Office of Management and Budget ( OMB ) to calculate the automatic spending reductions. First, OMB would reduce the difference between $1.2 trillion and the amount of deficit reduction achieved by the enacted legislation by 18% to account for debt service. That amount then would be divided by nine (the number of years remaining in the 10-year budget window if spending reductions first take effect in fiscal year 2013). The resulting sum is the amount by which spending must be reduced in each of fiscal years 2013 2021. If deficit reduction legislation from the Joint Select Committee is not enacted, the full $1.2 trillion would be reduced by 18% to account for debt service and subsequently divided by nine to calculate the amount of annual spending reductions required to achieve the law s budget goals. This amount then would be divided evenly between defense and non-defense spending. Spending reductions within those two categories then would be divided proportionally between discretionary spending and mandatory spending, although spending reductions to Medicare and certain health care programs would be capped at 2% for a fiscal year (see page 11). The chart below illustrates the spending reduction calculations under the BCA. The major steps to the enforcement process are outlined in the graphic on page eight. Hypothetical calculations of reductions required in defense, nondefense spending if automatic spending reduction process is triggered (billions of dollars) Description of calculation Hypothetical illustration #1: Enactment of Joint Select Committee bill reducing deficit by $900 billion Budget goal $1,200 $1,200 Subtract amount of deficit reduction in Joint Committee bill, if enacted $1,200 900 = $300 $1,200-0 = $1,200 Multiply difference by 18% to determine $300 * 0.18 = $54 $1,200 * 0.18 = $216 amount attributable to debt service Subtract the 18% to account for debt $300-54 = $246 $1,200-216 = $984 service savings Divide by nine to determine spending $246/9 = $27.3 $984/9 = $109.3 cuts for each year, FY 2013 2021 Divide by two to allocate between defense and non-defense spending $27.3/2 = $13.7 $109.3/2 = $54.7 Source: Congressional Research Service, The Budget Control Act of 2011 (August 19, 2011). Budget Control Act of 2011 Analysis Washington Council Ernst & Young 7 Hypothetical illustration #2: Joint Select Committee bill is not enacted (i.e., no deficit reduction)

Enforcement of budget goals Statutory spending limits established in the BCA are revised to: Redefine the defense and non-defense categories; and Set annual limits for each category through FY 2021. The OMB calculates the amount of deficit reduction required to be achieved in the defense and non-defense budget functions each year through the automatic process: Begin with $1.2 trillion (the budget goal) Subtract the amount of deficit reduction in the Joint Select Committee bill, if enacted Subtract 18% of the difference (attributable to debt service) Divide by nine to allocate the spending reductions equally across FY 2012 2021 Divide by two to allocate the spending reductions between defense and non-defense functions The annual amount of spending reductions required in the defense and nondefense categories are further divided proportionally between discretionary and non-discretionary spending within each category, resulting in four subcategories: Defense discretionary appropriations Defense direct (mandatory) spending Non-defense discretionary spending Non-defense direct (mandatory) spending The required spending reductions are implemented in three parts: Sequestration for discretionary spending in FY 2013 (January 2, 2013) Downward adjustment of revised discretionary spending limits for discretionary spending for FY 2014 2021 Sequestration for direct (mandatory) spending in each year from FY 2013 2021 Budget Control Act of 2011 Analysis Washington Council Ernst & Young 8

Political context The BCA gives the Joint Select Committee broad authority to include changes to Medicare, Medicaid, taxes, defense spending or any other federal program. The odds are slim that major entitlement reforms or tax changes will be included, as it would require bipartisan support to win approval in the Committee and the Congress. The BCA itself required bipartisan support to pass the House, where 95 Democrats joined 174 Republicans in approving the measure. The parties have generally drawn lines stipulating positions on key issues such as raising revenues or cutting entitlements. It is unlikely that a sufficient number of Republicans would support deficit reduction legislation that includes net revenue increases, and Democrats have not been willing to agree to major changes to entitlement programs absent revenue increases. As a result of the parties political stances and the short time frame for action by the Joint Select Committee, its legislation is more likely to include spending reductions along the lines of those discussed in deficit reduction negotiations led by Vice President Biden than larger scale programmatic changes to the tax code or entitlements. The CBO s August 24 update on the budget and economic outlook underscores the challenges to reducing the federal deficit. The annual CBO update projects that cumulative deficits for fiscal years 2012 2021 will be $3.5 trillion, a considerable decrease from the $6.7 trillion in cumulative deficits that the CBO projected in March. The CBO attributes about two-thirds of the reduction to the effects of enacting the BCA, but the update emphasizes that deficits will be significantly higher if: 1. The two-year extension of provisions designed to limit the reach of the alternative minimum tax ( AMT ), extensions of emergency unemployment compensation, and the one-year reduction in the payroll tax do not expire at the end of 2011. 2. Reductions of about 29.5% in Medicare payment rates for physicians do not take effect at the end of 2011. 3. Most of the provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111 312) do not expire on December 31, 2012, as dictated under current law. These provisions include the so-called Bush tax cuts (first enacted in 2001 and 2003, and extended for two years in 2010) and provisions of the American Recovery and Reinvestment Act of 2009. According to the CBO, extending the policies outlined above would increase cumulative deficits for fiscal years 2012 2021 by $5 trillion above the amount projected in the baseline, more than double the amount of deficit reduction projected to result from the BCA. The chart at right summarizes the effects on the deficit of continuing the policies, as well as the associated debt service. Budgetary effects of selected policy alternatives not included in the CBO s baseline (billions of dollars) Policy alternative Extend certain income tax and estate and gift tax provisions scheduled to expire on December 31, 2012 Index the AMT for inflation Extend certain income tax and estate and gift tax provisions scheduled to expire on December 31, 2012, and index the AMT for inflation* Extend other expiring tax provisions Maintain Medicare payment rates for physicians at the 2011 level Effect on deficit FY 2012-2021 Debt service Total -$2,461 -$443 -$2,904 -$690 -$119 -$809 -$3,949 -$698 -$4,647 -$761 -$159 -$920 -$298 -$53 -$351 Source: The Budget and Economic Outlook: An Update, Congressional Budget Office, August 2011. *The total includes an additional revenue loss of $799 billion over the 2013-2021 period that results from the interaction of the two policies. It is important to note, however, that there is some disagreement over which baseline is used to calculate deficit reduction under the BCA. Historically, Congress has used what is called a current law baseline, which adheres to current law, including the expiration of temporary tax provisions as scheduled. In contrast, using a current policy baseline assumes there will be no expiration of current law and therefore assumes extension of provisions such as the Bush-era tax cuts. The distinction is important because using the current policy baseline would permit the Committee to obtain deficit reduction credit for extending only a sub-set of the Bush-era tax cuts. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 9

Tax In 2011, tax reform has dominated the agendas of both congressional tax writing committees. The Senate Finance Committee and the House Ways and Means Committee have both held a significant number of hearings and meetings on the issue since the beginning of the year. Although consensus appears to be forming around the concept of reducing rates and limiting expenditures, the compressed time frame of the Joint Select Committee process and the current political climate might not lend itself to action on comprehensive tax reform. As such, the prospects of the Joint Select Committee including net tax increases and/or comprehensive tax reform as part of a deficit reduction effort are uncertain. The Joint Select Committee nonetheless could provide an opportunity to advance tax reform. House Ways and Means Committee Chairman Dave Camp (R-MI), who is a member of the Joint Select Committee, has raised the possibility of the Joint Select Committee including language in legislation it puts forward that would require Congress to enact tax reform within a specific time frame, possibly even in 2012. In an August 25 interview with Bloomberg, Camp said, You could certainly have some sort of approach that would have a date certain for tax reform that would be outside of the 100-day window for the Joint Select Committee to develop deficit reduction legislation. Driving the deliberations of the Joint Select Committee, it is anticipated that Committee members will represent the predominant views of their respective parties. Thus, Democrats are expected to advocate for including revenue proposals as part of a shared sacrifice agenda in any legislation that the Joint Select Committee puts forward. In deficit reduction talks led by Vice President Biden, Democrats proposed a number of revenue increases, including those outlined in the chart at the right. Similarly, Republicans are expected to continue their opposition to net tax increases with particular opposition to tax rate increases. In addition, Committee members likely will re-examine revenue proposals from prior deficit reduction efforts, including the Bowles-Simpson Commission and the Bipartisan Policy Center, as well as tax reform proposals from the House Budget Committee, and Sens. Ron Wyden (D-OR) and Dan Coats (R-IN) (see chart on page 14). For example, the Bowles-Simpson Commission proposed eliminating most tax expenditures and setting individual rates at 8%, 14%, and 23%, with an add-back mechanism for expenditures that would work in conjunction with increasing those rates. The Commission s goal was to keep the top individual tax rate from exceeding 29%, and the Commission aimed for a single corporate rate between 23% and 29%. Select revenue increases proposed by Democrats in deficit reduction talks led by Vice President Biden (billions of dollars over 10 years) Limit benefit of itemized deductions for high-income taxpayers Repeal of last-in/first-out ( LIFO ) method of accounting $300* $60 $70* Repeal oil and gas preferences $40* Tax carried interest as ordinary income $20* Change depreciation recovery period for corporate jets $3** * Joint Committee on Taxation estimate of Administration s Fiscal Year 2012 Budget Proposals ** Based on Administration statements There has been some speculation that President Obama might also propose that the Joint Select Committee include in its legislation a series of proposals aimed at creating jobs, possibly including the extension of a payroll tax cut set to expire at the end of 2011. However, these proposals could be taken up sooner in light of public pressure to spur job creation and shore up the economy. Implications of automatic spending reductions. With respect to the automatic spending reduction process that will take effect if legislation from the Joint Select Committee is not enacted, taxes are largely unaffected. The process would not trigger new revenue increases, and refundable tax credits are exempt from the sequestration process. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 10

Health care The health care community has remained on high alert about activity in Washington as stakeholders grapple simultaneously with payment reforms and significant reimbursement cuts included in the Patient Protection and Affordable Care Act of 2010 ( PPACA ); potential reform of the Medicare physician payment formula; and deficit reduction efforts, including the BCA, that could affect spending for federal health care programs. Although large scale entitlement reform proposals were included in the Bowles-Simpson Commission s final report, the CBO s Reducing the Deficit: Spending and Revenue Options, and the Senate Gang of Six s proposal (see charts on pages 15-17), it will be difficult for the Joint Select Committee to include significant programmatic reforms in any legislation it puts forward because of the short time frame that the law sets and the difficulty in forging bipartisan agreements on major changes to Medicare, Medicaid or PPACA. As such, attention has shifted to potential Medicare reimbursement cuts, which constituted a significant portion of the $334 billion to $353 billion in health care savings that House Majority Leader Eric Cantor (R-VA) said were identified in the deficit reduction negotiations that Vice President Biden led earlier this year (see chart on page 17). Notably, Medicaid is exempt from sequestration, but the Joint Select Committee could include proposals to reduce Medicaid spending in any legislation it puts forward. For example, improved care coordination for so-called dual eligibles people eligible for both Medicare and Medicaid was cited in the Biden negotiations as a source of as much as $5 billion in deficit reduction. Assessing Medicare implications under sequestration. Organizations have been studying the BCA to assess whether they are more vulnerable to cuts under legislation that the Joint Select Committee might propose or from the automatic budget goal enforcement process. Because cuts to Medicare payments to health care providers and health plans cannot exceed 2% per year under sequestration, a number of stakeholders in the health care space believe they might fare better under the automatic enforcement mechanism, concluding that the Joint Select Committee might include larger cuts to programs that affect their interests. To illustrate, the CBO s August 24 update on the budget and economic outlook projects that total Medicare spending in fiscal years 2013 2021 will be $6.846 trillion, 2% of which is approximately $137 billion. (Fiscal years 2012 2013 are the nine years remaining in the 10-year budget window that would be subject to a sequestration order if legislation that reduces the deficit by at least $1.2 trillion is not enacted.) However, based on CBO s current projections, cuts to Medicare as a result of sequestration would be less than $137 billion. First, only Medicare payments to health care providers and health plans are subject to sequestration (see below). Second, it is important to note that other factors will affect the amount of savings needed from Medicare. These factors include the overall amount of savings needed to achieve $1.2 trillion in deficit reduction divided evenly between defense and non-defense, and then the proportional breakdown of non-defense discretionary and mandatory spending (see pages seven and eight). Medicare spending subject to sequestration. Specifically, any sequestration order under the BCA would apply only to: 1. Individual payments under Medicare Parts A (hospital insurance) or B (insurance for doctors services, outpatient care, home health services, and other medical services) for services furnished during the oneyear period beginning on the first day of the first month beginning after the order is issued (or later in some cases). 2. Monthly payments under contracts under Medicare Parts C (Medicare Advantage) or D (Medicare prescription drug coverage) for the same one-year period. The special sequestration rules for Medicare bar increases in beneficiary charges for Part B services and direct the Secretary of Health and Human Services to disregard reductions in payment amounts resulting from a sequestration order for purposes of calculating any adjustment to payment rates for the Part C growth percentage, the Part D annual growth rate and the application of risk corridors to Part D payment rates. In addition, the special rules for Medicare exempt from sequestration: 1. Part D low-income premium and cost-sharing subsidies 2. Part D catastrophic subsidies 3. The qualified individual (QI) subsidy, which provides payments to states for coverage of Medicare costsharing for certain low-income Medicare beneficiaries. Because of the 2% cap on reductions in spending for Medicare and certain health care programs under sequestration, the BCA requires that the OMB increase the reductions required in discretionary appropriations and non-exempt non-medicare spending by a uniform percentage to offset the reductions not achieved in Medicare spending as a result of the 2% limit. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 11

Health care Implementation of PPACA. The BCA s automatic spending cuts also could hamper implementation of PPACA. In general, Democrats on the Joint Select Committee are unlikely to support major changes to the law. A notable exception could be the repeal or reform of the CLASS Act (Community Living Assistance Services and Support Act), which was included in bipartisan deficit reduction proposals offered by the Bowles-Simpson Commission and the Senate Gang of Six. Otherwise, implementation of the law might be affected more through potential automatic spending reductions under the BCA. For example, sequestration could reduce funding for PPACA s cost-sharing subsidies for individuals purchasing coverage in the insurance Exchanges. Unlike refundable premium-assistance tax credits, the cost-sharing subsidies do not appear to fall within one of the specific exemptions from sequestration. Medicare physician payment reform. The long-term Medicare physician payment problem is an issue in almost all budgetary considerations in Congress, and the BCA and the deliberations of the Joint Select Committee will be no exception. Payment rates for physician services will be reduced by 29.4% on January 1, 2012, under the Sustainable Growth Rate ( SGR ) formula unless legislation is enacted to prevent the cuts. Legislation avoiding cuts to Medicare payments to physicians on a short-term basis has been enacted since the SGR formula first required such cuts in 2003. The American Medical Association is at the forefront of a campaign to create a long-term solution to the physician reimbursement issue in legislation by the Joint Select Committee. Using the BCA as a vehicle to avoid the scheduled reimbursement cuts would require the Joint Select Committee to identify additional cuts or revenue to offset the cost of the so-called doc-fix beyond the minimum $1.2 trillion in deficit reduction that the Committee is charged with proposing. In a report dated June 16, 2011, the CBO estimated that maintaining physician reimbursements at their current level for 2012 would cost $12 billion, and the August CBO update on the budget and economic outlook projects that maintaining Medicare payment rates for physicians at 2011 levels would cost $298 billion over the FY 2012-2021 budget window. The challenge is underscored by the tradition of using spending reductions from other health care programs to offset the cost of the doc-fix, something that would be particularly difficult politically given the likelihood for other health care cuts in the context of deficit reduction. The FY 2012 budget proposal by House Budget Committee Chairman Paul Ryan (R-WI) advocated reforming the SGR, and the package of changes to the House rules that the new Republican majority approved in January outlined a strategy for Medicare physician payment reform that could be funded by repealing or modifying PPACA s individual mandate or modifying the law s subsidies for the purchase of health insurance. Democrats oppose those proposals. The Bowles-Simpson Commission proposed freezing reimbursement rates in 2013, decreasing rates by 1% in 2014 and reinstating the SGR formula in 2015 at the 2014 spending level. In its June 16 report, the CBO estimated that the proposal would cost $261.7 billion from 2012 2021. The Bowles-Simpson Commission s final report offered a set of specific options (see chart on page 15) for health savings that it projected would amount to nearly $400 billion from 2012 to 2020. The Senate Gang of Six also proposed reforming SGR but did not provide specific recommendations for funding it. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 12

Conclusion The Joint Select Committee will be the epicenter of legislative activity for the remainder of the year, and the Committee s deliberations could have significant implications for Medicare, Medicaid, taxes, defense spending or any other federal program. Given the size of the federal budget deficit and the current economic situation, the Budget Control Act of 2011 is best viewed as a first step in deficit reduction efforts. The deficit will be a major factor in looming debates over tax and entitlement reform, as well as efforts to spark economic growth and job creation. Furthermore, the 2012 elections are sure to keep the deficit and federal spending at the forefront of the political debate. More information For more information, contact any of the professionals at Washington Council Ernst & Young at +1 202 293 7474. Ernst & Young Assurance Tax Transactions Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the US. For more information, please visit www.ey.com. About Washington Council Ernst & Young Washington Council Ernst & Young (WCEY) is a legislative and regulatory advisory services group that helps clients seize opportunities and manage the risks associated with the federal legislative and regulatory process. Our practice covers domestic and international taxation; health care; energy; employee benefits; financial services and other issues. 2011 Ernst & Young LLP. All Rights Reserved. SCORE No. YY2541 This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither Ernst & Young LLP nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 13

Appendix I tax proposals Gang of Six Plan (as outlined in summary released on 7/19/2011) Wyden-Coats Bipartisan Tax Fairness and Simplification Act (4/7/2011) House Budget Plan (H.CON.RES.34 as passed on 4/15/2011) President s National Commission on Fiscal Responsibility and Reform (Bowles-Simpson) (12/1/2010) Bipartisan Policy Center s Debt Reduction Task Force Plan (Rivlin-Domenici) (11/18/2010) Overview Objective Deficit reduction/tax reform; tax reform required within six months Tax reform Deficit reduction/tax and entitlement reform Deficit reduction/tax and entitlement reform Deficit reduction/tax and entitlement reform Overall reduction in deficit and debt Change in spending and taxes (revenues historically at 18% of GDP) Claims to cut deficit over 10 years by $3.7/$3.6 trillion (vs. CBO baseline) and $4.65/$4.5 vs. Bowles-Simpson baseline $1 trillion tax increase; rest in spending cuts incl. lower payments for interest on debt (versus CBO baseline, it's a $1.5 trillion tax cut) Claimed to be revenue neutral relative to the administration s policy baseline i.e., no effect of the deficit or debt Cuts deficits to 1.6% of gross domestic product ( GDP ) by 2021; reduces debt held by the public to 67% of GDP by 2021 and 10% by 2050 Maintains revenues and spending 18%- 19% of GDP; all deficit reduction is accomplished on spending side largely via cuts to Medicaid and Medicare Reduces debt held by the public to 60% of GDP by 2014 and 40% by 2037 Reduces spending to 22% of GDP and revenues to 21%; deficit reduction achieved with 31% tax increases/69% spending cuts through 2020 (non-interest) Stabilizes government debt held by public at 60% of GDP by 2020 Reduces spending to 23% of GDP and revenues to 21.4% by 2020; deficit reduction achieved with 46% tax increases/54% spending cuts (noninterest) Corporate taxes Corporate tax rate Lowers corporate tax rate to a range between 23-29% Lowers corporate tax rate to 24% Lowers corporate tax rate to 25% Lowers corporate tax rate to 28% Lowers corporate tax rate to 27% Business tax expenditures Given the revenueneutral constraint placed on CIT, reduced rate would likely mean elimination of some business tax expenditures Reductions in many business tax expenditures; limits deductibility of interest to real interest only Unspecified, but base broadening cited as financing lower rate Eliminates all business tax expenditures Eliminates many business tax expenditures Research and development Not specified, but could be part of base broadening No extension of R&D credit Repealed Repeals research credit, retains expensing of R&D expenditures Accelerated depreciation Not specified, but could be part of base broadening Limits depreciation allowance to accelerated depreciation systems (ADS) Eliminated or modified, details not specified Retained International taxation Territorial (proposal says: "move to a competitive territorial tax system.") --- no other specifics Repeals tax deferral of active foreign earnings; reinstitutes per country foreign tax credit; repatriation holiday for 2011 with reinvestment requirements Territorial system, current taxation of passive foreign income retained, other details not specified Retains deferral and worldwide system with foreign tax credit Source: Ernst & Young LLP's Quantitative Economics and Statistics Group. Budget Control Act of 2011 Analysis Washington Council Ernst & Young 14

Appendix I tax proposals Individual taxes Individual tax rates Capital gains and dividends Individual tax expenditures Home mortgage interest deduction Exclusion for employerprovided health insurance Gang of Six Plan (as outlined in summary released on 7/19/2011) Lower rates with 3-rate system with ranges as follows: 8-12%, 14-22%, 23-29% Unspecified, but base broadening was cited as financing lower ordinary rates Summary says: "Reform, not eliminate, tax expenditures for health, charitable giving, homeownership, and retirement, and retain support for low-income workers and families." Elsewhere: "retain EITC and the CTC, or...at least same level of support for beneficiaries" Reformed but not eliminated Reformed but not eliminated Wyden-Coats Bipartisan Tax Fairness and Simplification Act (4/7/2011) Three individual tax brackets of 15%, 25% and 35% 35% exclusion for dividends and capital gains Triples standard deduction; retains most credits and deductions, such as deductions for home mortgage, interest and charitable donations, Earned Income Tax Credit ( EITC ) and child tax credit; repeals some exclusions, deferral and deductions Retained Retained House Budget Plan (H.CON.RES.34 as passed on 4/15/2011) Top rate falls to 25%; brackets consolidated and other rates reduced but not specified Unspecified, but base broadening cited as financing lower rate Unspecified, but base broadening cited as financing lower rate President s National Commission on Fiscal Responsibility and Reform (Bowles- Simpson) (12/1/2010) Three Individual tax brackets of 12%, 22% and 28% Bipartisan Policy Center s Debt Reduction Task Force (Rivlin- Domenici) Plan (11/18/2010) Two individual tax brackets of 15% and 27% Taxed as ordinary income Taxed as ordinary income Eliminates or limits most tax expenditures except for the EITC, child tax credit, reformed home mortgage deduction, charitable deduction, employer-provided health insurance exclusion Replaced with 12% nonrefundable credit for mortgage interest on primary residences Capped at 75th percentile of premiums in 2014, held constant until 2018, then phased out by 2038; excise tax lowered to 12% Replace home mortgage/ charitable deductions with 15% refundable credits; restructure EITC/child tax credit Current deduction replaced with 15% refundable credit available to all taxpayers, no credit for mortgage interest in excess of $25,000 Caps exclusion beginning in 2018; exclusion completely phased out by 2028 AMT Repealed Repealed Repealed Repealed Repealed Transition Relief (NOLs) Transition relief (NOLs, underappreciated basis, deferred tax assets, etc.) Not specified Not specified Not specified Transition relief not discussed, revenue estimate suggests little or no transition Not specified Other major changes Shift to chained-cpi government-wide, meaning smaller inflation adjustments for tax parameters & higher taxes on individuals over time; Seeks an additional $133 billion for Highway Trust Fund by 2021 w/out raising federal gas tax Source: Ernst & Young LLP's Quantitative Economics and Statistics Group. No new revenue sources No new revenue sources; Affordable Care Act and associated tax provisions repealed (e.g., unearned income tax, excise tax on Cadillac plans, employer penalties, coverage provisions subsidized via tax credits, etc.) Raise gas tax by 15 cents per gallon 6.5% Debt Reduction Sales Tax, actually operates as a credit invoice method valueadded tax ( VAT ); impose 1-cent per ounce excise tax on soft drinks beginning in 2012 Budget Control Act of 2011 Analysis Washington Council Ernst & Young 15