Unsanitized: The Tax Time Bomb That Congress Can Defuse

And how McConnell suddenly needs a bill to save his Senate majority. This is The COVID-19 Daily Report for December 17, 2020.

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First Response

With Mitch McConnell at the negotiating table for the first time, amazingly, in nine months, talks are creeping toward a deal on a coronavirus relief package of around $900 billion. Because of the rigidity of that $900 billion number, the reintroduction of $600 stimulus checks—half the size of the first round in March—has caused a four-week cut to the extension of enhanced unemployment—also half the size of the first round in March. The extra $300 per week was supposed to go for 16 weeks, now it’s targeted at 12.

It’s wrong to pit targeted relief for the unemployed against broader relief for the working class, especially as Republican desperation to secure a deal grows (more on that in a minute). But there’s another difference between the two types of relief: stimulus checks are not taxed, but unemployment benefits are.

This has been largely forgotten by the media and is assuredly unknown to most unemployment recipients. But the mass of unemployment benefits delivered this year—about $130 billion through October—are all taxable. One of the hidden reasons that poor people who were unemployed did so well under the CARES Act is because nothing was withheld from their unemployment benefits, including the $600/week federal boost. But all of those taxes are due, at the federal level and in 34 states that tax unemployment benefits, and the government will start asking for it in tax returns next year.

This is targeted anti-stimulus, on precisely the people hit hardest by the pandemic economically. But Congress has an option. In this relief package, it can make unemployment benefits during the pandemic non-taxable, and prevent a snap-back that will stunt economic recovery at the worst possible time, in the early months of next year, before vaccine takeup brings the economy back to life.

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The more you collected from unemployment without taking taxes, the more you’ll owe after the fact. This means that the most vulnerable people in America, the 3.94 million who have been out of work for over six months, have the most tax liability. The IRS does instruct people to withhold a portion of their unemployment insurance to “avoid a tax-time surprise,” but almost nobody does that. People in that position need all the money they can get.

One thing to note here is how this will manifest itself. As Howard Gleckman of the Tax Policy Center explained to me, the standard deduction was raised in the Trump tax law to $24,800 (NOTE: that's for married couples filing jointly. For single filers, the standard deduction for 2020 is $12,400). That’s likely to cover much of what even long-term unemployed people received in benefits during the pandemic. “If you lost your job in March, and your income was only unemployment insurance, you’ll still be paying no income tax on this and in many cases very little,” says Gleckman. Of course, if you had a higher-paying job that you lost, or if you earned above the standard deduction, you will owe money, perhaps a substantial amount.

The bigger problem is this. Typically, with the Earned Income Tax Credit and Child Tax Credits, the working poor would receive substantial money back in a refund. This has become an economic expectation for millions of people. Refund checks are often used to replace durable goods, like refrigerators or washer and dryers, or pay off credit card bills. “People have a system in their heads, they run up credit cards until February, then get the refund and pay them off,” Gleckman says.

That familiar trajectory will not exist in 2021, however, because of the looming unemployment tax bomb. Those living on unemployment will not get a refund, and depending on their earnings from early in the year may owe some money. Income from unemployment is not “countable” toward the EITC or CTC.

Combine that with another problem. Thanks to the $600/week boost, some poorer Americans may have higher income through unemployment this year than in years past. Because of the way the U.S. ties income levels to federal benefits, and because unemployment counts as income, some people may have to pay back things like tax credits to purchase health insurance, or nutrition assistance (commonly called food stamps). That will begin to hit people in the tax returns they file as soon as February. Keep in mind that these people will already see a gap in their benefits in January because Congress is so late with the extension. So it’s month after month of economic blows.

(A side note is that a similar situation applies to federal workers who were forced to take a payroll tax deferral that they will have to pay back starting in January. Almost no business adopted this, but federal workers had to. This will have the effect of double withholding for four months, after having no withholding since September. Those who didn’t plan will have to deal with smaller paychecks.)

This is significant anti-stimulus at the worst possible time. In effect, the one-time stimulus check and unemployment boost will be offset, for millions of people, by the lack of an expected refund and even tax liability. That blunts the impact of those relief measures. “This will not only affect individual households, but have some effect on the economy,” Gleckman says. “It’s taking money out of one pocket and putting it into another.”

That doesn’t have to be the end of the story. Congress has the authority, of course, to exempt all unemployment insurance since the beginning of the pandemic from federal taxation. It could also change the terms of various work-based tax credits for 2020 to ensure a similar level of benefit for those who were involuntarily unemployed in the pandemic. This has not been part of the negotiations thus far, and I’m sure the cost is a big hurdle.

But that’s just the point. Those costs will be borne by the unemployed—easily the people screwed the most in the pandemic. Somebody should stand up for them, or else they’ll get a rude awakening come tax season.

The New Democratic Leverage

Democratic leaders might protest that removing tax liability for unemployment benefits and increasing the length of the unemployment extension or the size of (and eligibility for) the stimulus checks increases costs, and Republicans have set a hard line at $900 billion. But Mitch McConnell let his slip show a little bit on why he ended up back at the bargaining table, without his cherished corporate liability shield, nine months after the CARES Act. On a private caucus call with GOP Senators, McConnell said direct payments were needed in the package because “Kelly and David are getting hammered.”

Kelly and David refers to Sens. Kelly Loeffler and David Perdue, contestants in runoff elections on January 5 in Georgia. McConnell is implicitly saying here that the outcome of those races, and consequently the Republican Senate majority, depends on passing a relief bill. So think about what that means: if about 13,700 votes shifted to Perdue in the November election, guaranteeing Republicans a 51st Senate seat, there wouldn’t be a relief package at all. Unemployment programs propping up over 13 million Americans would expire, evictions would resume, and the skyrocketing poverty rate would just keep going.

The second part of that is that McConnell is desperate. He sees his Senate majority slipping away, and needs to throw a bone to the public in order to secure it. That gives Democrats more ability to set terms than they might recognize. The relief package on the table is too small to produce broad relief. The direct payments and unemployment boost is at half the level of March. The lack of state and local fiscal aid will produce brutal austerity. And because it’s wrapped into an omnibus spending package that puts off the next must-pass bill until next September, it heralds a new normal of austerity.

Democrats don’t have to accept the austerity doom loop. McConnell is refreshingly blunt. He’s telling his caucus that he needs this bill to retain power. So how much is that worth to him? Enough to kill the corporate tax “double dip”? Enough to make unemployment non-taxable? Enough to add state and local back in? This really is the last train leaving the station, so Democratic leaders need to think hard about what they want, and what McConnell needs.

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