At the end of 2012, taxes are going up and spending is going down. If present law is not modified, the U.S. will experience a very stiff economic headwind in 2013 resulting from the implementation of laws already passed. Even less comforting is this fact: the only thing standing in the way of an economic disaster is a series of good decisions by congress.
Current estimates indicate such a shock would be equivalent to 3.5-5 percent of GDP. With GDP growth rates around two percent, it is easy to see why such a scenario would be so damaging. In simple terms, there is not enough economic growth to counter such a rapid increase in taxes and cuts in spending.
The Joint Committee on Taxation presented a report in January of this year outlining tax breaks set to expire between 2012 and 2022. At 70 pages, the document contains a list of expiring support for a range of policies that is sure to upset people across the political spectrum.
Over the short-term, there are several tax breaks that will expire affecting a large number of people. The expiration of the payroll tax cut, Bush tax cuts, alternative minimum tax patch and automatic budget cuts mandated by the debt ceiling deal will affect the largest portion of the population.
At the end of the year, the two percent payroll tax holiday enacted in 2011 and extended through 2012 will expire. This tax cut was passed as part of a budget compromise in late 2010 and presented as an important boost to the recovery. The Obama administration highlighted its importance to struggling citizens during the fight to extend the tax cut into 2012, making the case that it meant $1,000 annually to a typical family.
Bush tax cuts
Looming even larger over the U.S. fiscal outlook and households however, are the Bush tax cuts. Enacted in 2001 and 2003, these tax cuts became extremely polarizing over the years, in part, because of their size and makeup and also due to the current fiscal situation.
One estimate reported by CNN stated that the Bush tax cuts carry a value of $3.7 trillion over ten years. The Bush tax cuts brought rates down from a range of 15-39 percent to a range of 10-35 percent. In short, all income levels would be affected if their expiration were to be allowed. Furthermore, the child tax credit would be reduced in half going from $1,000 to $500 per child. Taxes on capital gains and dividends would also rise from their current 15 percent. Long-term capital gains or gains from assets held for more than a year would increase by 33 percent, going from 15 percent to 20 percent. Meanwhile, dividends taxed at 15 percent currently, would be taxed as ordinary income.
In real-life terms, analysis from the Wall Street Journal and American Institute of CPAs shows a single person making $40,000 a year would see their taxes increase by $400 a year. A couple earning $80,000 a year would see their tax bill increase $2,200.
Alternative Minimum tax
Also set to hit a large number of Americans is the expiration of a short-term fix for the alternative minimum tax. If this short-term fix were to expire, almost every married taxpayer with an income range of $100,000 to $500,000 will owe the government more money under the alternative tax, according to the Congressional Budget Office. An analysis by ABC News puts the impact at $3,900 to $8,000 more a year in taxes, on average for those hit with an increase.
Automatic budget cuts
Unfortunately, policymakers are not just facing decisions regarding tax increases. Due to the inability of leaders to reach a long-term deficit reduction deal during the debt ceiling debate and subsequent failure of the “super committee,” $1.2 trillion of spending cuts over the next ten years will be automatically implemented starting in 2013. The cuts are split evenly between domestic and defense programs. While many support fiscal restraint, the composition of the cuts mandated by the debt ceiling compromise is problematic, even for fiscal hawks.
It is important to note all of these tax increases and spending cuts are already written into law. If nothing is done to alter the course of fiscal policy, scenarios just outlined will become reality. However, most experts anticipate legislative action to prevent the execution of such a nightmarish confluence of bad policy.
Although these changes are set to take place in 2013, uncertainty makes it hard for families and businesses alike to plan ahead. As a result, decisions, particularly those requiring capital investments are put off or delayed. This kind of policy uncertainty acts as a sort of restraint, tempering economic performance.
Today, millions of Americans are without work or struggling to work the hours needed to provide for themselves and in many cases, their families. Those who do have jobs are struggling with stagnant wages and a higher cost of living. Furthermore, rising gas prices act as a tax, already erasing most of the positive impact from the payroll tax holiday.
In the summer of 2011, S&P downgraded the sovereign credit rating of the U.S. If the status-quo is maintained, America’s unsustainable fiscal trajectory would surely trigger more downgrades. Doing nothing is not an option. Another scenario could see one party holding out and using existing law to strengthen its negotiating position, which could be very disruptive to economic growth. The most anticipated scenario is one where congress, both in the lame duck session and in 2013, would pass legislation allowing for more palatable adjustments in tax and fiscal policy. However, to avoid deterioration in the country’s outlook, such a fix must also address the long-term debt trajectory. One point that must be clear to everyone is that gridlock is not good and is not a responsible option.
With such large policy questions hanging over the economy, the sheer magnitude of action required increases the chance for policy error. With high-stakes, any error on the part of policy makers could do real damage to the economy at a time when it is still vulnerable.