capital thinking update special edition - the budget control act of 2011

SPECIAL EDITION: Thursday, August 4, 2011

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The Budget Control Act of 2011 OVERVIEW

On Tuesday, the Senate passed and the President signed into law S. 365, the 74-page Budget Control Act of 2011. Shortly thereafter, as authorized by the legislation, the President unilaterally increased the debt ceiling limit by $400 billion. Doing so allowed the Treasury Department to continue processing tens of millions of checks this month, including the $23 billion that went to 28 million Social Security recipients yesterday, plus additional tens of billions in payments going later this month to soldiers, defense contractors, Medicare and Medicaid recipients and providers, and food stamp recipients. In addition, on August 15 the Department will be able to make payments on $25 billion in coupons and $27 billion of Treasury notes that come due on approximately $1 trillion in securities. With those crises averted, we now look ahead to what happens next as Congress and the President implement their respective elements of the new law.

A minimum of $2.117 trillion in total deficit reduction over the next 10 years is now required by law. The debt ceiling will be raised in additional stages over the next six months or so for a total increase of $2.1 trillion to $2.4 trillion, depending on the level of further cuts and “sequestration” (automatic spending cuts) that can be triggered if certain deficit reduction targets are not met within that time frame. The main features of the law producing these outcomes are these:

$400 billion in debt ceiling funding, as noted above, was available immediately at the request of the President on August 2.

$500 billion in additional debt ceiling authority will be available as needed, subject to a Congressional disapproval resolution that, if vetoed, would take a two-thirds supermajority of both Houses to override. Because we cannot envision a scenario in which that would occur, this further increase in the debt ceiling should be taken for granted.

This initial increase of $900 billion in borrowing authority will be fully offset by caps on discretionary spending over the next 10 years that are expected to generate $917 billion in savings, including a net $21 billion in FY2012. (If the caps are exceeded, discretionary spending will be sequestered on an across-the-board basis with very few exceptions so as to achieve the projected reduction in the deficit).

$1.2 to $1.5 trillion of further debt ceiling funding will be available to the President as necessary, subject to the same Congressional disapproval procedures as with respect to the $500 billion increase. This last increase, especially on the higher end, is anticipated to give the President sufficient room to get through 2012 and thereby avoid the need to address the debt ceiling issue again until 2013.

The amount of additional debt ceiling authority between $1.2 and $1.5 trillion will depend on what level of deficit reduction is proposed by the new “Super Committee,” passed by Congress and then signed into law. If no legislation is enacted, the President is limited to an increase of $1.2 trillion, which would then trigger a second possible sequester modeled on the Gramm-Rudman-Hollings Balanced Budget Act of 1985 (evenly split between defense and non-defense spending). This would include automatic cuts to all non-exempt discretionary, mandatory and entitlement program spending, totaling $1.2 trillion over 10 years. The legislation sets forth revised security and non-security allocations in the event that sequestration is needed.

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Given that cuts to defense spending must provide half the savings and that military pay is exempted, the impact on the defense industry would be particularly severe.

If deficit reduction legislation is enacted but the total savings fall short of $1.2 trillion, sequestration will occur to make up the difference between $1.2 trillion and whatever the legislation is scored to save. Thus, for example, if the Congressional Budget Office (CBO) determines that the legislation reduces the deficit by only $800 billion, an additional $400 billion in automatic cuts will occur through sequestration, divided equally between defense ($200 billion) and non-defense items, including discretionary, mandatory and entitlement program spending ($200 billion). Because some mandatory spending would be exempted, including Social Security, Medicaid and Medicare beneficiary payments, the law would further magnify the cuts that would be borne by other programs. Thus, for example, under this scenario government contractors providing goods and services across a wide spectrum could face even steeper cuts than anticipated.

In the unlikely event that no deficit legislation is enacted (or legislation is enacted but savings total less than $1.2 trillion) and Congress sends a Balanced Budget Amendment to the States by the end of the year, sequestration of up to $1.2 trillion will occur, and the President will receive $1.5 trillion of additional debt ceiling authority. (Since it takes a two-thirds vote in both the House and the Senate to send a Constitutional amendment to the States, we consider this circumstance to be highly unlikely.) Under the legislation, Congress must vote on the proposed amendment between October 1 and the end of the year.

"SUPER COMMITTEE" OF CONGRESS TO BE FORMED

The Joint Select Committee on Deficit Reduction (likely to be known as the “Super Committee”) will be comprised of 12 sitting Members of Congress. Speaker Boehner, Leader Pelosi, Leader Reid and Leader McConnell each will appoint three Members; Speaker Boehner and Leader Reid will select the Co-Chairmen.

The Super Committee’s goal is to produce legislation by November 23 that the Congressional Budget Office scores as reducing the deficit by $1.5 trillion. (As long as $1.2 trillion of deficit reduction measures are enacted into law, sequestration will not occur.) This level of deficit reduction can be produced through any combination of reductions in discretionary, mandatory and entitlement spending (such as moving to a “chained” CPI for purpose of calculating increases in Social Security benefits) and changes to the tax code, including eliminating so-called “loopholes” and tax preferences. That the word “tax” appears nowhere in the legislation is irrelevant. Taxes are clearly in play. Now.

IMPORTANT DATES

August 16: The Congressional leadership must have appointed the members of the Super Committee and selected its Co-Chairs.

September 16: The Super Committee must hold (or have held) its first meeting.

Mid-September: Not later than 50 days after receipt of the President's request for the initial $900 billion installment of debt ceiling authority, Congress must pass a resolution of disapproval if it wants to attempt to withhold $500 billion of it from the President. Such a Resolution of Disapproval could conceivably pass both the House and the Senate (as it is subject only to a simple majority vote). But it would be vetoed by the President and would require a two-thirds vote of both the House and Senate to override his veto.

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October 1: The new fiscal year (FY2012) begins with an initial net cut of $21 billion of the projected $917 billion in cuts over 10 years. This is also the date by which Congress will have to pass, and the President will have to sign, a Continuing Resolution (CR) of some length in order to avoid a government shutdown. The CR presumably will be limited by the $1.043 trillion discretionary spending cap for FY2012.

October 1 through December 31: During this period, both the House and the Senate must vote on whether to adopt and send to the States a Balanced Budget Amendment to the Constitution. Adoption requires a two-thirds vote in each legislative body.

October 14: The Super Committee must “consider” any recommendations from House and Senate committees with respect to changes in law necessary for deficit reduction, provided that the recommendations are transmitted to the Super Committee by this date. Nothing compels any House or Senate committee to send recommendations, and nothing compels the Super Committee to incorporate into its work any of the suggestions it receives from the committees.

November 23: By no later than the day before Thanksgiving, the Super Committee is required to vote on a report that contains recommendations that must be reduced to legislative language and scored by CBO as reducing the deficit over the next 10 years (through FY2021). It will take a simple majority vote of the Members of the Committee to advance legislation to the House and Senate (no proxy voting allowed). If there is not a majority vote (for example, if the vote is deadlocked 6-6), sequestration would begin following the President’s receipt of the last tranche of increased debt ceiling authority. If there is a majority vote in favor, the legislation would be considered under an expedited process that would force a simple majority vote by December 23 in both the House and the Senate, without amendments and not subject to a filibuster.

If the Super Committee fails to report legislation by November 23 (or either the House or the Senate fails to pass the legislation by December 23), the legislation would lose its privileged status and thus would no longer be considered under expedited procedures. Without those protections, the odds of the legislation moving forward would decrease, thereby increasing the risk of sequestration.

December 2: By this date, the report and accompanying legislative language and CBO score must be transmitted to the President, the Vice President, and Congressional leaders.

December 9: One week later, any committees in the House and Senate to which the Super Committee’s legislation is referred must have reported the legislation, without amendment. If the relevant House and Senate committees do not report out legislation by the 9, the Super Committee’s bill can be discharged from those committees.

December 23: Two days before Christmas, the House and Senate must have voted, up or down, on the Super Committee’s proposed legislation.

December 25: Distinctions between those who have been naughty and those who have been nice (or just plain lucky) will be evident.

December 2011 or January 2012: Within 15 days of a request by the President for the third and final installment of debt ceiling funding (totaling $1.2 to $1.5 trillion), Congress must pass a resolution of

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disapproval if it wants to attempt to deny this request. Again, we do not expect that such a Resolution, if passed, would be enacted given the President’s power to veto it.

January 15, 2012: Legislation further reducing the deficit by at least $1.2 trillion must be signed into law by today in order to avoid the sequestration process from commencing.

October 1, 2012: The new fiscal year (FY2013) begins. Topline discretionary spending will be limited to $1.047 trillion. Further, should the savings produced by the Super Committee and enacted into law not equal or exceed $1.2 trillion, sequestration of some magnitude will begin to take effect approximately one month before the November 2012 elections.

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In the following pages of this Special Edition of Capital Thinking, we offer our thoughts on how implementation of the legislation will drive the agenda in Washington for the remainder of the year, and how potentially fundamental changes to current law might affect you.

As a firm with deep public policy roots, we are proud of our ability to help clients exercise a right enshrined in the U.S. Constitution by petitioning their government. We have been at it since 1965, when Jim Patton encouraged a young White House aide named Tom Boggs to help him build a different kind of law firm, one that understood that all three branches of government could provide solutions to challenging problems. Since then, we have been joined by the Breaux-Lott Leadership Group, which has augmented our bipartisan depth and continues to help build our public policy practice. By combining political know-how, legislative experience and substantive knowledge of the law, our founders had a vision for helping clients achieve success. For our paying and pro bono clients alike, we look forward to helping them achieve their legislative objectives as Congress and the White House now engage in the intense effort to implement the Budget Control Act of 2011.

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Agriculture

LEGISLATIVE ACTIVITY

Debt Ceiling Implications on Agriculture Programs and the 2012 Farm Bill. The recently enacted Budget Control Act of 2011 will not include cuts to farm programs before 2013, but could result in cuts to agriculture programs in out-years and may lead to revisions to the Farm Bill later this year in advance of adoption of a new Farm Bill presently scheduled to occur next year. Under the Act, the Agriculture Committees may submit recommended cuts to the Super Committee by October 14. Developing these recommendations will require the committees to examine each USDA program and identify potential spending reductions in much the same way that it would in preparing the next Farm Bill.

We anticipate these potential changes to current law: modifications to the direct payment program (through which producers receive government payments regardless of commodity prices), reform of existing commodity support programs, and repeal of ethanol subsidies. The biggest area of contention, however, could be nutrition programs, which comprise more than 70 percent of USDA’s budget. Both the Supplemental Nutrition Assistance Program (SNAP, formally known as food stamps) and the Women, Infants, and Children (WIC) program could be subject to longer-term cuts as part of the Super Committee’s recommendations, which would set off a heated battle over cutting aid to low-income families. Ironically, agriculture programs could fare better if Congress fails to enact legislation and sequestration occurs. These programs are estimated to suffer across-the-board cuts of only about 4-5 percent under sequestration – potentially less than would be enacted under a deficit reduction package, if agriculture cuts that were included in earlier House and Senate proposals are any indication of the level of cuts agriculture programs can ultimately expect in such a package.

Budget, Appropriations


Debt Ceiling Implications. As noted in the overview, the initial debt ceiling increase of $900 billion will be offset by spending reductions achieved through 10-year discretionary spending caps scored to generate $917 billion in savings. The second debt ceiling installment of $1.2 to $1.5 trillion will be contingent on deficit reductions recommended by the Super Committee and approved by Congress or, in the event an agreement cannot be reached, through a sequestration process that would mandate across-the-board reductions to all non-exempt discretionary, mandatory and entitlement spending over 10 years.

Following are highlights of how the Budget Control Act of 2011 could affect the FY2012 appropriations process and public agencies that benefit from programs funded through annual appropriations.

New and Improved FY2012 Spending Cap. The FY2012 overall discretionary budget authority cap set by the Budget Control Act of 2011 is $1.043 trillion ($684 billion for security and $359 billion for nonsecurity spending). By contrast, the House FY2012 Budget Resolution (H Con Res 34) established a $1.019 trillion cap (the current FY2011 discretionary spending level is $1.050 trillion). Republican House appropriators have indicated they will revise their 302(b) allocations to reflect the new budget authority cap, but final spending

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allocations will likely be addressed during the House / Senate conference of the bills or through enactment of a CR.

Security and Nonsecurity Spending. The Budget Control Act of 2011 defines “security” spending to include the Department of Defense; the Department of Homeland Security; the Department of Veterans Affairs; the National Nuclear Security Administration; the Intelligence Community Management Account; and International Affairs. For FY2012 and FY2013, the Act establishes a “firewall” between security and non-security spending that will prevent domestic account reductions from being used to offset increases in security spending. While this provides some relief for many programs of relevance to public agencies, such as those in the housing and energy fields, Homeland Security programs – including FEMA first responder programs – will be further jeopardized as they will compete against Pentagon priorities when cuts are determined.

Spending Caps Going Forward. Overall discretionary budget authority is capped at $1.047 trillion for FY2013 ($686 billion for security and $361 for nonsecurity), which is similar to FY2011 and FY2012 figures – higher levels than provided in the FY2012 House Budget Resolution. However, going forward through FY2021, overall growth is capped at 2 percent, presumably less than inflation. It is important to note that these are overall caps, and the distribution of budget authority among the various spending bills will remain under the jurisdiction of the Appropriations Committees. Moreover, the firewall between security and nonsecurity spending will be removed in FY2014, thus setting up a future debate over funding for programs important to public agencies.

The Super Committee. Because the Members must be appointed by August 16, 2011, Members have already begun to lobby Congressional leadership for seats on the Super Committee. The only certainty at this point is that the committee will be comprised of 12 Members – three Republicans and three Democrats from each chamber. It is unclear whether any appropriators will be included on or if membership will be limited to leadership, tax writers, and authorizers. By November 23, 2011, the Super Committee must present a package of spending cuts totaling $1.2 - $1.5 trillion over the next decade. These reductions may be achieved through any combination of discretionary, mandatory, and entitlement savings, as well as tax reform. Social Security, Medicaid, and Medicare beneficiary payments would be exempted. Congress must vote on this proposal by December 23.

Sequestration. As detailed in the overview, a sequestration process enforcing across-the-board cuts will occur in the event that deficit reduction legislation is not enacted by the end of the year and/or for any fiscal year spending caps are exceeded. If a sequestration process is triggered to offset the second debt ceiling installment, the spending cuts will be included in any FY2012 appropriations measure (individual bills, omnibus, or CR) that have not been passed by December 23 and in future legislation. Though subject to expiration, tax expenditures such as low income tax credits, earned income tax credits, new market tax credits, and municipal bonds would not be directly affected by sequestration. The best case scenario for a number of interest groups will lie in a small-scale reduction to programs through sequestration as opposed to potential select large-scale reductions that may be proposed by the Super Committee.

Likely Scenario for the FY2012 Appropriations Process. Even with the establishment of an overall discretionary budget authority cap that will enable the appropriations process to resume in the House and essentially start in the Senate, at least one CR for FY2012 is inevitable. The length and substance of a CR will be negotiated when Congress returns in September. While appropriators should be incentivized to wrap

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up as many FY2012 spending bills as they can before the Super Committee assumes jurisdiction over spending cuts, or sequestration reductions are implemented, it is very unlikely the House and Senate will be able to come to terms on many, if any, appropriations bills before November 23. The content of Super Committee’s proposed legislation, if reported, will likely determine whether appropriators move toward an omnibus bill or a year-long CR.

In the near-term, the Senate will set its 302(b) allocations (which will reflect Democratic priorities), and Senate Appropriations Subcommittees will start mark-ups in September. House appropriators have indicated they are beginning to work on a CR (the length of which is yet to be determined). Thus, the three FY2012 spending bills currently pending in the House Appropriations Committee – State-Foreign Operations, Labor-HHS-Education, and Transportation-Housing – will not be reported out of the committee, but instead incorporated into the CR.

Education


Higher Education. Under the debt ceiling agreement, certain repayment incentives on loans are eliminated effective July 1, 2012, which will save the government $21.7 billion over the next 10 years. Specifically, the bill eliminates the interest subsidy on subsidized student loans for almost all graduate students while a borrower is in school, in the post-school grace period, and during any authorized deferment period. Therefore, borrowers will be responsible for the interest accrued on those loans while in school going forward. Additionally, the bill eliminates a partial rebate of the origination fee for on-time repayment of federal loans but still allows the current interest rate reduction for borrowers who agree to repay their loans through automatic payment.

The savings realized from these changes to the Federal Student Loan Program will be used to partially fund the Pell Grant program, which will receive $10 billion in FY2012 and an additional $7 billion in FY2013 through the legislation (the same amount offered by Speaker Boehner in his deficit reduction proposal). As such, the Budget Control Act of 2011 maintains the maximum award at $5,550 at least for FY2012, which many conservative House freshmen opposed. While the program would be protected from sequestration, it could be on the chopping block in the Super Committee. Additionally, other higher education programs could be vulnerable to cuts imposed through an automatic trigger if both chambers do not enact legislation.

K-12 Education. The impact of the debt-ceiling agreement on K-12 education, particularly Title I and Individuals with Disabilities Education Act (IDEA) programs, remains unclear. However, significant changes to education funding will likely take place through the FY2012 appropriations process, proposed cuts recommended by the Super Committee or through sequestration.

Congress has yet to pass the Labor-HHS-Education spending bill for FY2012, which is one of the larger annual spending bills and will likely be targeted for significant cuts in order to reduce FY2012 spending levels by $7 billion, as required by the Budget Control Act of 2011. In February, the Administration proposed a $2 billion increase in education funding. Congress is not likely to adopt the proposed increase. Although the Budget Control Act of 2011 preserved the Pell Grant program at desired funding levels by the Administration,

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adopting the $2 billion increase is highly unlikely in the House because, for many Republicans, elimination of the Administration’s signature programs, such as Race to the Top, remains a priority.

In finding up to $1.5 trillion in cuts, the Super Committee will likely place education programs on the table, although the Administration has made clear that education remains a priority. Small federal programs such as Striving Readers and Educational Technology state grants will likely be cut, if not eliminated, as these programs were eliminated under the President’s proposed FY2012 budget. The Department of Education would also face sequestration if the Super Committee fails to identify at least $1.2 trillion of deficit reduction measures and such reductions are not enacted into law. For those in the education community, sequestration may be a preferable alternative. However, because the Budget Control Act of 2011 provided a larger budget target than the House budget resolution originally set for FY2012, senior appropriator Representative Steven LaTourette (R-OH) has indicated that some domestic programs targeted for large cuts, like those in the Labor-HHS-Education bill, may now see a reduction in those anticipated cuts.

Energy


Debt Ceiling Implications. With the Super Committee set to formally begin discussions by mid-September on how to reduce the deficit by at least $1.2 trillion over the next 10 years, we expect energy tax incentives to be in play, including tax expenditures of interest to the oil and gas industry (e.g., section 199) and energy tax incentives of interest to the renewable sector that are slated to expire in the next few years.

Oil and Gas: The President has steadfastly called for an end to fossil fuel tax preferences. The Administration has proposed to repeal what it characterizes as “subsidies” enjoyed by the energy industry, including section 199 (which it estimates would save $17 billion over 10 years), the percentage depletion allowance for oil/gas wells ($10 billion), and the expensing of intangible drilling costs ($8 billion). When combined with other provisions, such as repealing the deduction for tertiary injectants and the exception to passive loss limitations for working interests in oil/gas properties, the Administration estimates that it could generate almost $40 billion in additional revenue over 10 years—revenue that would not have to come from the defense industry or other sectors. In the current environment, the oil and gas industry faces the risk that enough Republicans would support changes to current law to avoid reductions in defense spending that otherwise will occur if Congress cannot meet the deficit targets established in the Budget Control Act of 2011. We thus expect that the Administration and the Democratic leadership will urge the Super Committee to recommend ending tax preferences for oil and gas companies, even if only those provisions that principally benefit major integrated oil companies.

Renewables: Unlike the tax preferences enjoyed by oil and gas companies, the principal tax preferences written into the code that benefit the renewable industry must be routinely extended. These include the utility-scale wind production tax credit that is set to expire on December 31, 2012; the biomass, geothermal and marine/hydro credits that are set to expire on December 31, 2013; and Treasury’s popular “Section 1603” grants-in-lieu-of tax credit (that many solar projects have taken advantage of), that is also set to expire this year. Given the Senate’s vote to repeal the decades-old ethanol tax credit earlier this year, a provision thought to be sacrosanct, nothing should be taken for granted in the current environment. Congress may

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allow clean energy credits to lapse (as has been done before) or may even terminate them early in order to raise additional “revenues” for deficit reduction purposes.

Post-Recess Legislative Activity

Clean Energy Jobs. Senate Majority Leader Harry Reid and House Minority Whip Steny Hoyer would like their respective legislative bodies to focus on a “jobs agenda” next month. Whether they offer jobs measures as a package or as stand-alone pieces, the two leaders want clean energy job incentives included in any final legislation sent to the President. Movement on a much broader “Clean Energy Standard” has thus far stalled in the Senate Energy and Natural Resources Committee.

Critical Minerals. Senate Energy and Natural Resources Committee Ranking Member Lisa Murkowski (R-AK) is working towards a bipartisan compromise so that the Committee can consider critical minerals legislation in September. She is the lead sponsor of the Critical Minerals Policy Act of 2011 (S. 1113).

REGULATORY ACTIVITY

CCS. The Environmental Protection Agency will seek public comments on a proposed rule to exempt underground sequestration of carbon dioxide from hazardous waste regulations. It is part of an effort to provide regulatory certainty under a national framework intended to help advance the use of carbon capture and sequestration technologies. The proposed rule will be published in an upcoming Federal Register notice.

DOE General Counsel. President Obama has nominated Gregory H. Woods to be the Department of Energy’s (DOE) General Counsel. He is currently the U.S. Department of Transportation’s Deputy General Counsel. His appointment is subject to Senate confirmation.

2013 Solar Decathlon. Applications to host DOE’s 2013 Solar Decathlon competition are due August 29.

Hydraulic Fracturing. The Secretary of Energy’s Advisory Board/Natural Gas Subcommittee will meet on August 15 to discuss an interim report to the Board and recommendations regarding shale gas.

Financial Services


Debt Ceiling Implications. Passage of the Budget Control Act of 2011 may be insufficient to protect the nation’s AAA credit rating, potentially impacting access to capital by state and local governments, and perhaps others. The debt crisis, though resolved, also increases the complexity of pending financial services reform efforts.

The proposals offered in the negotiations leading to the Budget Control Act of 2011 compromise were characterized by some of the credit rating agencies as being inadequate to prevent the downgrade of the United States’ credit rating. Despite the crisis being averted, some economists, investors, and financial analysts remain concerned with the ability of the U.S. to retain its AAA rating, though Moody’s and Fitch have announced that they will not downgrade the current rating, at least for now. Should the credit rating be downgraded, such activity would negatively impact the credit ratings for state and local governments, frustrating cash-strapped counties, cities and municipalities in their efforts to provide basic services.

http://www.epa.gov/epawaste/nonhaz/industrial/geo-sequester/index.htm

http://www.solardecathlon.gov/apply.html

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A downgrade of Treasuries would have a ripple effect through other markets that use Treasuries as a reference or benchmark, potentially increasing the cost of credit in numerous markets, including the housing market. The repurchase agreement (repo) market also utilizes Treasuries as collateral for literally trillions of dollars of short-term financing transactions. A downgrade could force higher fees, or “haircuts,” as a result of the degradation of the collateral. Furthermore, the State and Local Government Series (SLGS) market (which was closed as the government approached the debt limit) is critical to municipal issuers as it is the one place they can invest unspent bond proceeds without worry of violating arbitrage restrictions. However, if there is a downgrade of Treasuries, added costs and inconveniences will be imposed on state and local governments.

REGULATORY ACTIVITY

With respect to financial services regulatory reform, the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Federal Reserve, and other agencies have been working with limited resources and overwhelming pressures to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). One year after the law was signed into law by President Obama on July 21, 2010, regulators have missed deadlines for dozens of new rulemakings and studies mandated to be completed, new offices and agencies have failed to launch, and the agencies’ staffs continue to sift through piles of comment letters and meet with interested parties on the various proposals.

Federal financial regulators are being asked to do more than ever before and with no more and, in some cases, less resources. The political climate demanding spending cuts particularly affects the SEC and CFTC, as the Dodd-Frank Act tasks them with new duties, such as oversight of the $600 trillion derivatives market. The increased scope cannot be understated. As CFTC Chairman Gary Gensler explained, “it is as if the [CFTC] previously had the role to oversee the markets in the state of Louisiana and was just mandated by Congress to extend oversight to Alabama, Kentucky, Mississippi, Missouri, Oklahoma, South Carolina and Tennessee – we now have seven times the population to police.”

At the same time, the dynamics surrounding the Congressional appropriations process, particularly in the Republican-controlled House, indicate that the regulatory agencies will have the same or less funding in FY2012 than they had in FY2011, before they assumed their new Dodd-Frank Act responsibilities. Though Congress increased the CFTC’s budget in April 2011 to $202 million, less than requested by the White House, the reduced funding has been attacked, in part as a Republican-led effort to delay Dodd-Frank implementation. In June, the House approved a reduction in funding for the CFTC by $30 million, or 15 percent of its budget.

Similarly, the House Appropriations Committee recently approved $1.2 billion for the SEC. This is equal to FY2011 spending but $222 million less than the White House’s request for $1.407 billion. In addition to budget restrictions, the SEC has been under attack by Congress. Most recently, House Financial Services Committee Chairman Spencer Bachus (R-AL) announced that he will introduce legislation to consolidate SEC offices and institute managerial and ethics reforms.

While the Budget Control Act of 2011 does not identify specific cuts to the regulatory agencies charged with implementing the Dodd-Frank Act and other financial markets reform, Congress seems intent upon limiting new spending and regulations that increase federal government spending. The mandates of the Budget Control Act of 2011 may give those in Congress opposed increasing the appropriations of the financial regulators additional leverage to withhold increased agency funding needed to implement the Dodd-Frank Act. When Congress returns

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in September, these issues will be closely tied to the discussion of a struggling housing market and anemic job creation, and will become more pronounced as the 2012 elections approach.

Health Care


Debt Ceiling Implications. While Medicare and Medicaid survived the immediate tranche of cuts, the almost $1 trillion reduction in discretionary spending caps will adversely affect funding to various health agencies, including those within the Department of Health and Human Services, the Food and Drug Administration, the Centers for Disease Control, the National Institutes of Health, and the Health Resources and Services Administration.

The bigger threat, of course, lies in the potential cuts to Medicare and Medicaid with the newly established Super Committee charged with finding a minimum of $1.2 trillion in savings. Assuming the committee meets the deadline and deficit reduction legislation is enacted, payments to health care programs are almost certain to take a heavy hit. All deficit reduction proposals to date should be considered on the table, particularly those that have been scored and would produce significant savings, including cuts to graduate medical education programs, home health providers, labs, rural hospitals, Medigap and Medicaid reform measures, just to name a few. Health care reform and new programs created by the Affordable Care Act are also vulnerable, including delivery system pilots and demos and support to the newly established health insurance exchanges, adding additional pressure to states already in fiscal crisis.

Legislation reported by the Super Committee would be an addition to the already-scheduled cuts to health providers such as the impending 29.5 percent cut to physician payments in Medicare scheduled to take effect on January 1, 2012. While the Super Committee legislation could serve as a potential vehicle to address the longstanding issues related to the Sustainable Growth Rate and annual physician fee fix, the proposal would require further offsets elsewhere (currently a $300 billion problem).

Appointments to the Super Committee will be critical for the health care industry, as lobbying efforts to shield various health programs from cuts have been intense to date.

Failure to meet the deadline creates a different set of challenges to the health care sector given the parameters of the sequestration trigger. Medicaid, low income programs, and fraud and abuse programs would all be protected from the sequestration process. Medicare beneficiaries would also be protected, so cuts to the program would be restricted to reductions in provider reimbursements. The Office of Management and Budget could reduce Medicare payments across the board by up to 2 percent, which would include reimbursements to hospitals, physicians, nursing homes, Part D and Medicare Advantage plans. Cuts to Medicare providers, however, will certainly have a trickle down impact on beneficiaries regardless of the direct shield in the sequestration process as the financial squeeze on providers creates access issues for patients.

The bottom line for the health care industry is that the debt ceiling deal only let health care stakeholders live to fight another day. The remainder of the 2011 calendar will look a lot like the first half, with lobbying and advocacy efforts growing in intensity to mitigate almost-certain cuts.

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International, Defense, Homeland Security


Debt Ceiling and Related Spending Developments. The debt ceiling compromise includes a two-pronged plan to cut U.S. national security spending, broadly defined to include capping appropriations for military construction, foreign operations, the intelligence community, and the budgets of the Departments of Defense, State, Homeland Security and Veterans Affairs. The total cap for FY2012 is $684 billion, with military and civilian spending on Iraq and Afghanistan exempt from that total. The first prong consists of identifying $350 billion in spending reductions in those areas over 10 years. The second prong requires the Super Committee to find an additional $1.2 trillion in security and non-security cuts or additional tax revenues by fall 2011 (the timeline is outlined in more detail in the introduction to this report). If Congress and the President do not agree on those cuts by the deadline imposed by the agreement, the automatic across-the-board spending reductions enter into force, including up to an additional $600 billion in the defense budget.

The Obama Administration and many Congressional Democrats point to the defense trigger as one of the Democrats’ few clear victories in the debt ceiling debate. They believe Republicans ultimately will have to choose between some tax increases and accepting a level of defense spending cuts that many conservatives view as draconian. Indeed, several Republicans prominent on defense issues, such as Senate Armed Services and Defense Appropriations Committee Member Lindsey Graham (R-SC) and House Armed Services Committee Member Randy Forbes (R-VA), cited the reductions in national security spending as their primary rationale in voting against the debt ceiling package. House Armed Services Committee Ranking Member Adam Smith (D-WA) also pointed to the defense cuts as one reason for his vote against the compromise. In response, Defense Secretary Leon Panetta and White House spokesman Jay Carney note the Administration hopes to avoid triggering the automatic $600 billion in cuts, but it will seek and expect a “balanced” deficit reduction package to emerge in their place.

Whether Congress and the President avoid the trigger or not, liberal and conservative defense analysts point to certain Pentagon programs as possible targets for spending reductions over the next several months. The F-35 Joint Strike Fighter (JSF) program remains a candidate for cutbacks, as some governmental and non-governmental observers question the applicability of JSF’s capabilities to the current threat environment. U.S. troop levels in Western Europe, and particularly East Asia, will come under close scrutiny as well. Senator Tom Coburn (R-OK) has cited the Pentagon’s commissary program as ripe for cost reductions. The Super Committee also likely will examine potential cost savings from military health care reform and reductions to the U.S. nuclear arsenal.

Elsewhere in the national security arena, although State/foreign operations and homeland security funding are much smaller in absolute terms, they are perhaps more imperiled on a relative basis than the politically popular and often-sacrosanct defense budget items. As part of the ongoing negotiations in the fall, many analysts expect Republicans to seek further cuts in the State Department’s foreign assistance budget to offset potential reductions in Pentagon and intelligence spending.

Free Trade Agreement (FTA) Developments. On Wednesday evening, Senate Majority Leader Reid and Senate Minority Leader McConnell issued simultaneous statements outlining a “path forward” in the fall for Trade Adjustment Assistance (TAA) and the pending FTAs with Colombia, South Korea, and Panama. The most likely

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scenario is that the House will vote to pass the lapsed Generalized System of Preferences (GSP) trade preference program for developing countries. The Senate likely then will amend the GSP bill to attach the bipartisan TAA compromise package, subsequently approving both. Meanwhile, the Obama Administration officially will submit the trade agreements, enabling the House to consider and pass TAA and the FTAs in four separate bills. Under this scenario, the Senate then will take up and pass TAA, followed by each of the FTAs. Senator Reid will insist on passing TAA first. Timing remains a question, as Leader Reid reportedly balked at specifically mentioning “September” in the joint statement with Leader McConnell.

Tax


Debt Ceiling Implications. Despite a statement earlier this week from Senate Finance Committee Chairman Max Baucus (D-MT) suggesting that comprehensive tax reform cannot be ruled out entirely, we consider the time frame too short for the tax writing committees to produce comprehensive tax reform measures that could be adopted by the Super Committee. Still, we have little doubt that potential changes to corporate taxes could emerge in the final package produced by the Super Committee, particularly proposed revisions to permanent provisions in law or those that do not expire until the end of 2013 or beyond since they can act as revenue raisers. (Contrast this to the “Bush tax cuts” that are set to expire at the end of 2012 – the “repeal” of which beyond 2012 will not count for deficit reduction purposes using a Congressional Budget Office/Joint Tax Committee baseline.)

A few targeted provisions repeatedly pushed by Congressional Democrats and the Administration during the negotiations leading up to the Budget Control Act of 2011 will almost certainly receive further airing in the Super Committee. These include repealing oil and gas incentives to the tune of at least $40-45 billion (e.g., section 199 for the oil and gas industry), reclassifying the taxation of carried interest ($15 billion), corporate jet depreciation ($3 billion), and the last-in, first-out (LIFO) method of accounting (up to $75 billion). While Republicans have to date firmly rejected the inclusion of tax expenditures as part of any deal, we cannot rule out the potential for partisan bargaining with the potential to include in the debate expenditures favored by Democrats (e.g., existing renewable energy tax credits) once such measures are squarely in play. This is especially so with the prospect of significant defense spending cuts by way of sequestration looming should a deal by the Super Committee not be reached.

TechComm


The Budget Control Act of 2011 does not contain any of the spectrum auction and public safety provisions that were included in S. 1323, the version of debt ceiling legislation introduced last week by Senate Majority Leader Reid. Nonetheless, wireless, public safety, and industry stakeholders believe that there is enough momentum for a spectrum package to move through Congress later this year.

Senate Commerce, Science, and Transportation Committee Chairman Jay Rockefeller IV (D-WV) said he continues to push for floor action on his public safety spectrum bill, S. 911, and to get it signed into law by the

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10th anniversary of the September 11, 2001 terrorist attacks. That outcome appears unlikely, although it is possible that the Senate could vote on the bill by the anniversary.

Leader Reid’s bill had included reallocation of the so-called 700 MHz “D-block” spectrum, $7 billion for deployment of a public safety broadband network, incentive auction authority for the Federal Communications Commission, and the auction of other frequencies. However, the auction provisions in the Reid plan ran into complaints from House Republican leaders, who threatened to "blue slip" the bill, or kill it without taking it up, because it raised revenues. (The Origination Clause of the U.S. Constitution gives the House the sole authority to initiate revenue-raising legislation.) That disagreement prompted Congressional leaders to scrub the spectrum provisions altogether, leaving the committees of jurisdiction back in control of the legislation.

Many proponents of Chairman Rockefeller’s bill opposed the stripped-down language in the Reid bill and favored spectrum legislation moving through “regular order” rather than face a fast track in Budget Control Act of 2011. S. 911 would reallocate the D-block to public safety, reserve nearly $12 billion for construction and maintenance of a nationwide public safety broadband network and establish a governance structure to oversee the public safety network. It also would provide for streamlined approval of modification of wireless facilities to aid in swift broadband buildout. S. 911 also would authorize the FCC to hold incentive auctions of spectrum relinquished voluntarily by broadcast and satellite licensees, although broadcasters worry that the legislation in its current form does not afford interference protection or assurances that television viewers will continue to have access to their over-the-air channels, among other concerns.

In addition to S. 911, the House Energy and Commerce Committee is crafting its own version of spectrum legislation. Discussions between Democratic and GOP leaders of the committee continue in the wake of competing discussion drafts that parties floated earlier this summer. The key sticking points center on the approach to the D-block, which Republicans would rather see auctioned to raise revenues for the U.S. Treasury. Republicans also favor a network-of-networks approach to governance of the public safety network over the formation of a nonprofit corporation that Democrats support to oversee network deployment.

There appears to be a good chance Congress could pass spectrum legislation later this year - either as a stand-alone bill such as S. 911, or as a result of the process the Budget Control Act of 2011 would establish in which the Super Committee would look for up to $1.5 trillion in additional deficit reduction. The committee could target spectrum, particularly if one of the 12 members of the joint debt ceiling committee considers spectrum legislation as a priority.

Transportation


FAA Reauthorization: While the House and Senate have been unable to agree on a 21st extension of the FAA Reauthorization bill, which lapsed on July 23, it is likely the stalemate will soon end, thus allowing the 21st extension to pass by consent during a pro forma session of the Senate as early as Friday, August 5th. As a result of the failure of Congress to reauthorize FAA programs and taxing authority before it left town earlier this week, more than 4,000 FAA employees have remained furloughed and work on airport improvement projects across the country has been suspended. Further, the FAA has not been collecting an estimated $200 million in aviation-related taxes every week. The standoff has its origins in a provision in the House-passed

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extension that would eliminate Essential Air Service (EAS) funding from certain rural airports, including airports in the States of Senate Majority Leader Reid and Senate Commerce Committee Chairman Jay Rockefeller (D-WV). The underlying issue, however, continues to be the difference between the House and Senate on a labor issue – in particular, the rules for union elections in the airline industry. The EAS cuts are generally seen as a negotiating tactic on the broader labor issue. Despite heated rhetoric from the President, Secretary LaHood, FAA Administrator Babbitt, and Congressional leaders, the Senate has to date refused to pass the House extension with the EAS provision, and the House (before leaving for recess) refused to pass a clean extension. We expect that to change tomorrow, when the Senate will likely pass the House bill subject to assurances from Transportation Secretary LaHood that the proposed EAS cuts will not go into effect immediately.

Transportation Appropriations: The discretionary spending caps in the Budget Control Act of 2011, discussed throughout this edition of Capital Thinking, constrain discretionary spending. They do not apply to programs funded through the Highway Trust Fund -- which accounts for most surface transportation spending -- or the Airport and Airways Trust Fund. While the spending caps will significantly restrain discretionary transportation spending over the ten-year period, the caps are much less severe than the cuts that would be enacted under the House’s FY2012 Budget Resolution.

Programs Impacted

• The non-security spending caps will constrain discretionary transportation spending, including transit New Starts, TIGER, High Speed Rail, Amtrak capital and operating funding, and all FAA programs except for the Airport Improvement Program (AIP). These programs will have to compete with all other discretionary programs for funding under the annual non-security spending cap. However, because programs funded through the Highway Trust Fund are funded via contract authority and are considered mandatory spending, they fall outside of the caps. Furthermore, the Act only caps discretionary budget authority and not outlays, so it will not put downward pressure on Highway Trust Fund spending from the outlay side. As a result, the Act spending caps will not have a direct impact on highway, transit and safety programs funded through the Highway Trust Fund or on programs funded through the Airport and Airways Trust Fund.

Assessing the Impact

• The Act effectively freezes domestic spending in FY2012 and FY2013 at FY2011 levels, which were in turn reduced 3.8 percent from FY2010. This means that the Act will reduce non-security spending by only $2 billion in FY2012 versus the FY2011 enacted level. By comparison, the House FY2012 Budget Resolution would have reduced non-security programs by $46 billion versus FY2011. The House allocation for FY2012 would have cut spending for the Transportation-HUD subcommittee alone by $7.7 billion versus FY2011 – the largest percentage reduction of any appropriations subcommittee. However, it is important to remember that the Act only sets overall caps for security and non-security spending. As a result, the distribution of budget authority within the caps remains subject to the Appropriations Committees – and the specific amount allocated to the Transportation-HUD Subcommittee for FY2012 is yet to be determined.

• Ultimately, the primary impact of the Budget Control Act of 2011 for discretionary transportation programs is to make it extremely difficult for there to be any substantial, general-funded increase in infrastructure

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funding from FY2011 levels. In addition to the effective freeze in FY2012 and FY2013, the Act caps subsequent year-over-year increases to approximately 2 percent.

To achieve the funding levels in the FY2011 CR, Congress cut discretionary transportation programs, including zeroing-out High Speed Rail funding, reducing transit New Starts from $2 billion to $1.597 billion, and reducing Amtrak capital and operating support and FAA facilities and equipment. However, Congress also continued the TIGER program at $527 million and the TIGGER program at $50 million.

As a result, the Act will significantly imperil big-ticket items, including High Speed Rail or a National Infrastructure Bank, should that be proposed to be funded through general fund appropriations. The Act will constrain the ability to significantly expand New Starts and air traffic control spending, unless reductions are made in other areas. For example, Senate Environment and Public Works Committee Chairman Barbara Boxer (D-CA) has said that the Senate’s $109 billion proposal assumes approximately $2 billion in general fund appropriations for New Starts in FY2012 and FY2013. While there should be sufficient funding to sustain the New Starts program at the $1.6 billion range, it will be a challenge to meet the higher targets without reductions in other areas.

In general, the discretionary spending caps make it very difficult for there to be any major increase in infrastructure spending without new revenue into the Highway Trust Fund through the reauthorization process.

SAFETEA-LU Reauthorization. With Congress having been consumed by the debt ceiling debate, the House and Senate entered the August recess with neither having released or marked-up their respective reauthorization measures, but with plans to do so in early September. The current extension expires on September 30, almost certainly requiring a short-term extension as the House and Senate work to move their respective bills through committee and to the floor.

• Senate Action: In the wake of the debt ceiling deal and the Democrats’ pivot to a jobs agenda, President Obama called for action on infrastructure investment and Senate Majority Leader Reid specifically stated that the Senate should bring its two-year, $109 billion reauthorization bill to the floor in September. The Senate bill would fund the surface transportation program for two years at current levels plus inflation, requiring an additional $12 billion in revenue to make up for projected shortfalls in the Highway Account over that period. Senate Finance Committee Chair Max Baucus (D-MT) has been working to identify a revenue source, and has stated that he is “optimistic,” but also made clear that the debt ceiling negotiations had to play out first. The lack of a top-line number from Senate Finance has been the primary reason -- along with the debt ceiling debate -- why Chairman Boxer has yet to bring the bill to a mark-up, and why the Banking Committee has not moved forward with the transit title. In his post-debt ceiling remarks, Majority Leader Reid indicated that Chairman Baucus has found ways to fund a bill at current levels, prompting his statement that the bill could come to the floor in September. Finance Committee staff has since said only that they are “working on offset options and determining which can get the support needed to move forward.” EPW Ranking Member James Inhofe (R-OK), otherwise a strong proponent of the bi-partisan Senate bill, has said that his support will depend on how the $12 billion is raised. The ability to move a bill on the floor will also depend on Republican support for the revenue mechanism.

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• House Action: The House Transportation and Infrastructure Committee is expected to release and mark up its bill in September as well, but floor time has not yet been set aside. Under the House Budget Resolution, the size of the House reauthorization bill is limited by the projected revenues in the Highway Trust Fund, which continue to decline as cars become more fuel efficient. Given this constraint, Chairman Mica’s six-year, $230 billion bill would reduce spending by 34-36 percent from current annual funding levels. The Committee leadership has spent the recent weeks making refinements to its draft and meeting with Committee Democrats, who remain opposed to the bill due to the funding level. Chairman Mica has also said that he would be working with the House Ways and Means Committee on revenue options.

• Potential Impact of the Super Committee: It is possible that the Super Committee will address Highway Trust Fund revenues as part of a comprehensive package, thus removing the key barrier to a long-term reauthorization. Both the Bowles-Simpson Commission and Gang of Six included additional Highway Trust Fund revenues in their respective deficit plans. In particular, the Gang of Six proposal included an additional $133 billion over ten years in revenues from tax reform to stabilize the Highway Trust Fund at current levels. The Super Committee will be considering legislative proposals from the jurisdictional committees, including Senate Finance and the House Ways and Means Committee. While it is possible that the Super Committee will be a vehicle to address the revenue issue, we expect the House and Senate to move forward with release and mark-up in September to maintain a credible path towards completing work on a reauthorization bill late this year or early next year.

capital thinking update special edition - the budget control act of 2011

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