What's At Stake With the Fiscal Cliff?

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I was astounded recently to hear someone say they believe the talk of a “fiscal cliff” is artificial and not a legitimate threat. There is an artificial component to it in that government created it, but the threat is legitimate, and not only will it impact everyone of us in one way or another, even if an agreement is reached in Washington, but the cumulative economic impact could be significant.

There are several components to the so-called “fiscal cliff,” some of which are less widely known than others. Most people are aware that the present six income brackets taxed at rates of 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent will expire, and revert to the pre-Bush era five income brackets taxed at rates of 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent. Without some reconciliation in Congress, everyone, even those at poverty level, will see their taxes increase.

The marriage tax penalty will return. The tax code, before the 2001 EGTRA (Economic Growth and Tax Relief Reconciliation Act), required a husband and wife to pay more in taxes when they filed jointly than they would as single taxpayers. This will expire the end of the year as well. According to calculations from the tax publisher CCH, the marriage tax penalty translates to a nearly 17% increase in taxes for those married couples who file jointly, regardless of bracket.

There are also more than 70 so-called tax extenders scheduled to expire on December 31. These are tax breaks for businesses and individuals that are technically temporary but usually end up being extended. They include the itemized deduction for state and local sales taxes, tuition and fees, and educators' out-of-pocket classroom expenses.

The Jobs and Growth Tax Relief Reconciliation Act of 2003, or JGTRRA, temporarily reduced the capital gains tax rate. Most capital gains have been taxed at 15 percent for the past nine years, and investors in the 10 percent and 15 percent tax brackets have not had to pay any taxes on profits from appreciated asset sales. Qualified dividends have also been taxed similarly. We now will revert to the pre-JGTRRA capital gains rate of 20 percent. The zero capital gains rate for low-income filers will return to 10 percent, and stock dividends will be taxed as ordinary income, meaning the top rate could be as high as 39.6 percent.

The Child Tax Credit will expire, which means each head of household will only be allowed a $500 deduction for each qualifying child as opposed to the current $1,000 deduction.

Currently, all taxpayers, regardless of income, are allowed to claim full annual exemption amounts for themselves and dependents. This exemption will be reduced or eliminated for higher income households.

For those who itemize deductions with their tax returns, the old limits will return. The aggregate of itemized deductions for higher income taxpayers will be reduced by three percent if the deductions exceed an annual threshold of a taxpayer's adjusted gross income.

Currently, childcare expenses of up to $3,000 for one child and $6,000 for two or more dependents are allowed. This will change back to $2,400 for one child, and a maximum of $4,800 for two or more children.

Also, the Estate Tax will revert to previous levels. Currently, an estate of greater than $5.1 million will be taxed at 35%, but after the first of the year, any estate over $1 million will be taxed at 55%.

For the past three years, the maximum number of weeks of unemployment insurance available in states with very high unemployment rates (8.5 percent or higher) was 99 weeks. That included 26 weeks of regular unemployment insurance, 53 of Emergency Unemployment Compensation, and 20 of Extended Benefits. At the end of the year, the emergency and extended benefits expire, reverting to a maximum of 26 weeks, or six months of unemployment benefits.

The so-called AMT Patch also expires. The Alternative Minimum Tax was implemented in 1969 to ensure that wealthy taxpayers were not using tax loopholes or taking excessive tax breaks to reduce their tax liability disproportionately. It was never indexed to inflation, so the fairly high income levels of the AMT 43 years ago are low by today’s standards. With the patch expiring this month, the AMT exemption drops from $48,450 to $33,750 for single filers, and from $74,450 to $45,000 for married couples. Many more middle-income taxpayers will fall under AMT tax parameters.

The convergence of all of these expiring tax policies, combined with the sequestration, or forced reduction in spending of $1.2 trillion over nine years, and the rapid approach to the federal debt limit of $16.5 trillion, and we have a veritable fiscal cliff, or, as some refer to it, a fiscal abyss.

The Congressional Budget Office has warned the economy would contract by nearly 1% if the tax issues are not resolved by the end of the year. However, the impact would likely be much more than that. Christina Romer, the former chairman of the Council of Economic Advisors, has calculated that tax increases of one percent of GDP lowers real GDP by roughly three percent. The combined tax increases listed above amount to nearly 2% of GDP, which will plunge the U.S. into another recession.

A deal will undoubtedly be reached before the end of the year to extend, adjust, or modify some or all of these components to the fiscal abyss.  However the fact remains that all of this financial havoc is threatened because the president insists on raising the top income tax rate from 35% to 39.5%, which will raise approximately $65 billion per year; enough to fund the government for about six days. It is both illogical and imprudent to threaten the nation with such fiscal havoc over six days of government funding. But with the media firmly behind him, he is inexplicably portrayed as the principled and prudent player in the negotiations. If all current tax rates are allowed to expire, the impact for 2013 alone will be $388 billion in new revenue, but would, according to Romer and most economists, thwart our fragile recovery and induce a new, deep recession.

The president’s own Simpson-Bowles deficit reduction commission responsibly recommended $3 in cuts for every $1 in revenue increase. Only a serious attempt at reducing spending will narrow the yearly deficit gap, which has averaged $1.44 trillion for each of the past four years.

The House majority favors a plan, much like Mitt Romney suggested, of limiting deductions at a proposed $50,000. The Tax Policy Center estimates that approach would raise nearly $800 billion over a decade, nearly $300 billion more than allowing the top two tax bracket rates to revert to pre-Bush levels, and have a much less pejorative effect on the economy.

If serious spending cuts are not made, even with higher taxes levied against the top income brackets, and long-term fixes are not made to Social Security or Medicare, the nation will continue the race toward the fiscal abyss, and the consequences will be much more devastating, and irreversible.

AP award winning columnist Richard Larsen is President of Larsen Financial, a brokerage and financial planning firm in Pocatello, and is a graduate of Idaho State University with a BA in Political Science and History and former member of the Idaho State Journal Editorial Board. He can be reached at rlarsenen@cableone.net.

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