Fiscal Cliff Timebomb Still Ticking

It is a Friday which is the second to last business day of 2012. 

A host of taxpayer friendly provisions of the Internal Revenue Code expire Tuesday (most of which were tax cuts made while George W. Bush was President that were given expiration dates in order to comply with Congressional budgeting rules).  A 2011 deal on the federal budget deficit mandates automatic major federal government spending cuts as well in 2013, only a few of which (apparently among them the Defense budget) have been modified in subsequent legislation.

Transfer Tax Expiration

As of this post, Congress has not taken action to address these matters, which are collectively known as the fiscal cliff.  This is particularly relevant in the case of gift and estate taxes: "In 2010, after a year in which the estate tax was zeroed out altogether, Congress passed a law that set the estate tax at 35% and exempted all estates under $5 million, adjusted for inflation. That law expires in January 2013 when the exemption will fall to $1 million and the tax will rise to 55%."  The expiration of transfer tax cuts is particular partisan, since, by definition, it involves tax cuts for rich people who haven't earned what they are receiving.  Republican calls to repeal the transfer tax system entirely have been replaced by efforts to make the generous provisions of the transfer tax laws in 2012 permanent.

Estate tax reforms are also more time sensitive.  If Congress doesn't reach a deal by Monday, people will die in 2013 and be subject to the less generous transfer tax laws unless Congress changes them retroactively, a prospect that grows more faint as each day passes.  In contrast, while income tax rules govern transactions taking place in 2013, (almost) no one is required to file a tax return paying taxes on those 2013 transactions until April 15, 2014, leaving Congress plenty of time to make retroactive changes that have no impact on anyone but tax professionals and business transaction planners.

Prospects For A Deal By Year End Are Modest

The President has offered to preserve the tax breaks for taxpayers making less than $250,000 a year and made some spending proposals.  Congressional Republicans discussed, but apparently have failed to pass, a counterproposal that would preserve tax breaks for taxpayers making less than $1,000,000 a year and some different spending proposals.  Neither side in the negotiations have indicated that a deal is imminent or outlined the terms of a deal seriously being considered by both sides.  This is a game of chicken that most conventional wisdom had assumed would produce a deal and hasn't.

A week from now, the winners of the 2012 elections will be sworn in, but this doesn't change the partisan balance of power in Congress or the Presidency, although it does slightly shuffle the deck by bringing new players into the discussion.  Mostly, however, the 2012 elections were not kind of moderates, so the party leadership the controls the flow of bills in the House and Senate respectively may take an even harder line.

Not A True Crisis, But A Serious Moment

Public opinion polls indicate that Republicans will pay a higher price than Democrats for failing to reach a deal on the fiscal cliff.

A resolution of the fiscal cliff is not "must pass" legislation that would trigger a constitutional crisis.  The tax laws that will take effect are laws that the United States managed just fine under during the Clinton administration.  Everyone knows what the laws will be if no action is taken.  The changes will increase tax revenues and reduce government spending.  This will reduce the $1,327 billion a year federal budget deficit by an estimated $560 billion dollars a year (which is about 42% of the current federal deficit), and this is what a significant number of Americans want. 

The government will not shut down if Congress doesn't reach a fiscal cliff deal.  Also, nothing prevents Congress from reaching new deals in 2013 and even making changes to the tax code retroactive. 

But, a failure to act will leave a pall of uncertainty over a wide variety of transactions whose tax treatment may be the subject of ongoing discussions and over any plans based on federal spending that faces automatic cuts.  Where Congress will not act, it should make this clear immediately to reduce uncertainty. 

This sudden shift in the federal government's public finance policies could (according to Keynesian economics) slow down a tepid recovery from the worst recession since the Great Depression that followed the financial crisis of 2007, or even trigger a double dip recession before we have fully recovered from the last recession.

The Details

Key elements of the specific elements of the fiscal cliff are discussed here. 

Tax Increases

Some highlights are the tax changes other than those in estate and gift taxes are as follows:

* The earned income tax credit will become much less generous.
* A temporary cut in the employee share of Social Security tax rates to 4.2% from the usual 6.2% will expire.
* "People earning more than $50,000 would face an increase in the tax rate on capital gains to 20 percent, from 15 percent. Dividends, which are currently taxed at a 15 percent rate, would also be taxed as ordinary income, with the top rate rising to 39.6 percent. . . . the Affordable Care Act ["Obamacare"] applies a new surtax of 3.8 percent on capital gains for wealthy Americans, pushing the top capital gains rate up to 23.8 percent."
* "Singles who make over $200,000 and married couples who earn over $250,000 would see their tax brackets rise from 33 percent and 35 percent to 36 percent and 39.6 percent, respectively."
* The exclusions from the Alternative Minimum Tax which currently impacts 4 million to 5 million taxpayers with annual incomes between $200,000 and $1 million will expire, causing it to apply to 31 million taxpayers.

The total tax increase will be about $400 billion a year (an increase of about 16%).

The estate and gift tax changes are very abrupt and rather arbitrary.  While the 2012 estate and gift tax rates and exemptions were extraordinarily generous, the 2013 transfer tax provisions will be more strict than those that Americans have grown accustomed to for many years.

I have very little sympathy for people who have lost the benefit of extraordinarily low and economy distorting low capital gains and dividend rates, and also have little sympathy for upper middle class and high income families seeing modest increases in their marginal tax rates at a time when the nation is running a large budget deficit.

The earned income tax credit rollback will affect a lot of people who are still struggling after the financial crisis, and the AMT expansion is also probably somewhat overbroad.

A number of alternatives to the scheduled tax provisions for 2013, such as the taxation of some municipal bond income, limitations on the mortgage interest deduction, and limitations on the state and local tax deduction, make better sense than some of the tax changes that are scheduled to take effect.

Spending Cuts

On the public spending side:
* "more than 40 percent of the nearly 5 million Americans [i.e. 2 million people] who have been unemployed for more than six months will lose benefits at year's end."
* Defense spending must be cut by $55 billion a year for each of the next ten years.  In 2012, this part of the budget was $716.3 billion, so the cut is about 7.7%.
* non-Defense discretionary spending must be cut by $55 billion a year for each of the next ten years "in everything from infrastructure to schools, to public health and homeland security." In 2012, this part of the budget ws about $655 billion, so the cut is about 8.4%.
* Payments to Medicare providers will be cut by 2% in 2013, an $11 billion cut.

But, "Social Security, Medicaid, supplemental security income, refundable tax credits, the children's health insurance program, the food stamp program and veterans' benefits are excluded from the cuts scheduled under the cliff. The White House has also said that military personnel would be exempt from the cuts."

The impact on the long term unemployed will be harsh, although some if it may be mitigated by migration to federal and state welfare programs.

The non-Defense discretionary spending cuts are probably steeper than can be made without really dire cuts to critical federal government services and programs.  The Defense discretionary spending cuts are less catastrophic since they can mostly be dealt with by partially delaying new major military procurement programs muting the impact on operations, but are still deep.

Bottom Line

Most of the provisions of the fiscal cliff are quite tough but most are not horrible and address a genuinely big federal budget deficit by dealing with unduly lenient Bush era tax cuts, temporary tax code provisions meant to be temporary, and by putting pressure on federal spending.

Congress and the President would be best advised to use the fiscal cliff status quo as a baseline to tweak, rather than undoing it on a wholesale basis.  At least partial relief for the unemployed, EITC receipients, some of the people newly subject to the AMT, and more urgent aspects of non-defense discretionary spending programs are the areas most in need of tweaking.  But, on balance, we are right to end a long era of debt financed tax cuts for the wealthiest Americans, which makes up the largest share of the fiscal cliff.