Toward the Abyss

May 29, 2012

While the upcoming campaign and elections seem to grab the bulk of the news headlines, the outcome of the elections may not play the lead role in the drama unfolding in the economy. The next administration and the next Congress may be the ones to debate the fundamental issues of tax and budget reform. But the current administration and Congress may have more to say about the course of the economy over the next few years than most people realize. Between now and the elections or in a postelection lame-duck session, our current legislators must decide the fate of the recovery and the course of the economy over the next few years.

The U.S. economy is facing a virtual fiscal cliff of tax increases, automatic spending cuts, and an impending breach of the debt ceiling that, if mishandled, could return this sputtering economy into an economic free fall. Such a reversal would surely hamstring any effort of the next administration and the next Congress to deal with longer-run issues, forcing them instead to focus on yet another cyclical downturn.

Let’s take a closer look at this cliff we seem hell-bent on driving off.

Tax Increases

If Congress fails to extend a slew of expired and expiring tax provisions, an estimated $500 billion tax increase will occur on January 1, 2013.

On December 31, tax cuts enacted in 2001 and expanded in 2003 and 2010 will expire. Those cuts include lower individual marginal income tax rates, lower capital gains and dividend tax rates, and business tax incentives. Unless Congress acts, on January 1, 2013, the top marginal rate for individuals earning $200,000 or more a year ($250,000 for couples filing jointly) will jump from 35% to 39.6%; other rates will rise in kind. The tax hikes under Obamacare that take effect on January 1 raise individual rates even higher. These individual rate increases will be borne by small businesses that file as individuals.

The estate tax, which is particularly burdensome for family-owned businesses, will also go up in 2013. Currently, the maximum estate tax rate is 35%, and estates valued at up to $5 million per person are exempt from the tax. On January 1, 2013, the exemption value will drop to $1 million, and the maximum rate will climb to 55%.

Capital gains will be taxed at a top rate of 20%, and dividends will be taxed as ordinary income. Finally, marriage penalties will increase, and various tax benefits for education, retirement savings, and low income individuals will disappear.

Congress generally “patches” the alternative minimum tax (AMT) every year to help it keep pace with inflation. As a result, just over 4 million tax returns are subject to the AMT. The most recent AMT patch expired at the end of 2011. If a new patch is not enacted retroactively for 2012, estimates suggest that more than 30 million taxpayers will be subject to AMT for 2012, and that number will increase to more than 40 million by the end of the decade.

The 2% payroll tax holiday and extended unemployment insurance benefits will disappear at the end of 2012, causing employee payroll taxes to increase from 4.2% to 6.2% and reducing the number of weeks individuals can collect unemployment insurance.

A substantial reduction in Medicare payments to physicians required by law has been deferred through continued “doc fixes” since the early 2000s. The current fix expires, leading to a nearly 30% reduction in Medicare physician payments.

Various tax “extenders,” such as the research and experimentation tax credit and the state and local sales tax deduction, expired at the end of 2011. Others, such as the production tax credit, will expire at the end of 2012. Many of these provisions have existed for decades, are long-accepted provisions of the tax code, and are routinely renewed by Congress. Taxpayers have come to expect that these provisions will be extended. Inaction by Congress on these extenders will have a negative impact on jobs and the fragile economy.

Debt Ceiling/Sequestration

Given the current level of government spending and allowing the Treasury some leeway in financing expenditures, it is likely that the government debt issuance will once again bump up against the debt limit between late December and the end of the first quarter of 2013. The last time the limit was substantively debated—in the fall of 2011—it prompted a bitter partisan fight that was only resolved with the establishment of a Super Committee tasked to find a suitable amount of spending cuts. When the Super Committee failed miserably, Congress resorted to a “meat ax” approach of across-the-board spending cuts to be imposed in early 2013. The debate this time promises to be no less vehement and no more productive.

The sequestration process that cuts $1.2 trillion over 10 years from government spending is scheduled to begin in early January. The process limits the cuts to Medicare and exempts Medicaid and Social Security. The cuts would begin on January 15, 2013, and would be in addition to any previously agreed-upon spending reduction in these discretionary spending components.

Economic Impact

What does this mean for our economic recovery? In January, the Congressional Budget Office (CBO) provided its estimate as part of its baseline scenario in The Budget and Economic Outlook. CBO is required to estimate its budget projections based on current law; thus, the CBO baseline is an assessment of what would happen if the tax provisions and sequestration process discussed in this article are not changed.

Under the CBO baseline, growth is expected to slow from 2.2% in 2012 to only 1.0% in 2013 and to remain below its potential rate until the first half of 2018. Estimates by Mark Zandi, from Moody’s Analytics, suggest that the fiscal drag will subtract more than 3.0 percentage points from GDP in 2013.

According to CBO, slower projected growth will result in a weaker labor market. The unemployment rate is projected to rise from an average of 8.8% in 2012 to 9.1% in 2013 and to only gradually decline thereafter. Economists believe that failure to address this impending fiscal cliff will lead to significantly worse economic outcomes in the near term compared with current policy.

The question now is, What, if anything, will Congress do to avoid running the economy over this cliff? The Senate has failed to pass a budget for the last three years. Chairman Paul Ryan (R-WI) has passed a budget in the House that focuses on the long-run fiscal problems but has yet to make any headway in the Senate. The administration’s only “achievement” in fiscal policy has been to run up three of the largest deficits in American history and cumulatively add more to the amount of debt than all the administrations before it.

With the upcoming election, few believe that Congress or the administration can agree on a course of action. Thus, it is likely that the decisions will fall to a lame-duck. In this environment, punting the issue to the next Congress and administration seems the most likely outcome, but even this modest achievement may be beyond the ability of a time squeezed lame duck. If that happens, the new Congress and the next administration may be dealing with the old problems of avoiding recession rather than focusing on a new beginning.




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