What You Should Know About ‘The Cliff’

Much has been written and said about the fiscal cliff. This summary and analysis from the Tax Foundation notes that the current situation "is the culmination of a decade of ‘temporary’ tax and budget bills that have postponed resolution of key policy differences." It looks ahead to the next steps. An example:

Estate Tax Increase
The estate of an individual who dies on December 31, 2012 will pay a federal estate tax (or death tax) of 35 percent on anything above $5.12 million. If the decedent instead passes away the next day, and Congress has not yet acted to change the law, the estate will instead owe a 55 percent tax on anything above $1 million. Even President Obama, no defender of estate tax repeal, considers this level too high: he has urged a compromise proposal of a 45 percent tax on estates over $3.5 million. Republicans generally support complete repeal of the tax.

There are few taxes that are as polarizing as the estate tax. A 2009 poll by the Tax Foundation found that the estate tax is viewed by taxpayers as the most "unfair" of all federal taxes but at the same time the estate tax seems to be a rallying point for those that agitate for redistribution through the tax code.[3] (In 2009, the estate tax raised about $20 billion, from a very small number of estates.) Opponents argue that the estate tax can break down family businesses while creating large compliance costs which are a drag on the economy.

Despite this seeming rift, there is a large and growing body of research by economists that generally lean left-of-center pointing toward repeal of the estate tax.[4] Nobel laureate economist Joseph Stiglitz, who served as chairman on Bill Clinton’s Council of Economic Advisors, authored a paper which argued that the estate tax actually increases inequality by reducing savings and driving up returns on capital (which largely benefit wealthy holders of capital).[5] Economist Larry Summers, former Treasury Secretary under President Clinton, co-authored a paper in 1981 that showed that the estate tax has severe impacts on the accumulation of privately held capital. Using Summers’ methodology, a July 2012 study by the Joint Economic Committee Republicans showed that since its inception, the estate tax has reduced the capital stock by approximately $1.1 trillion.[6]

The estate tax also encourages firms to structure as corporations instead of as family businesses, because corporations do not pay estate taxes when the person at the helm changes. Family businesses, however, can be subject to rates of over half the value of the estate when a deceased owner transfers the business to their heirs. This observation should be disconcerting to left-leaning voters, who recognize that smaller family businesses have ties to their communities. It should also concern right-leaning voters, who should see this as a distortion of the market process.

Perhaps the worst aspect of the estate tax is how uneven its impact is in practice. By utilizing careful estate planning, many wealthy taxpayers are able to shield much of their income from taxation upon their death. The people that tend to get hit the hardest are those that die unexpectedly, or, like farmers, have their assets tied up in illiquid holdings.[7] The estate planning industry has grown in size over the years as estate law becomes more complex. Three studies have even found that the compliance costs associated with the collection of the estate tax are actually higher than the amount of revenue the tax brings in.[8] Almost the entire estate planning industry can be thought of as economic waste, because it would not exist without the estate tax, and the high-skilled labor and capital utilized in that industry would be applied to other, more productive economic endeavors if the estate tax were repealed.

2011 and 2012 marked the first time in a decade that the estate tax rate and exemption level have been the same for more than one year. For 2010, the president and Congress (unintentionally) allowed the estate tax to expire completely, an outcome unexpected by most observers. While a repeat in 2013 may be desirable, exactly what happens remains to be seen.

Fiscal Cliff: How Steep Are We Talking?

The Bush tax cuts, set to expire after this year, represent only the tip of the fiscal iceberg before Congress. Unfortunately, considerable political attention is being focused on only the highest individual tax rate bracket. What’s actually at stake is of much, much more fiscal significance and can be divided into two parts.

"Taxmageddon," a nearly $500 billion per year increase in taxes starting day one of the New Year and federal spending cuts totaling more than $100 billion.

The list below outlines the variety of tax and fiscal matters that will require congressional action before the end of 2012.

To illustrate the scope of the potential dilemma: The so-called Buffet Rule to tax millionaires at a minimum effective rate of 30 percent would generate a relatively minuscule $5 billion annually. That number pales in comparison to the dollars involved with any one of the issues outlined. Examples: The payroll tax holiday costs $117 billion, the sequestration is $110 billion and another Alternative Minimum Tax (AMT) patch is $92 billion, while the extenders account for $78 billion. Or compare that potential $5 billion in new revenue to the amount of tax that simply goes uncollected each year – estimated by the U.S. Treasury to be $450 billion a year.

Many economists fear Taxmageddon alone would plunge the nation into another recession. Yet politicians continue to fight over philosophy, thus ignoring the big (dollar) picture that could have so much impact. The issues are many, the dollars are huge and the time is short. Little is likely to get done before the election. This leaves only a limited number of weeks in November and December for a lame duck Congress to resolve a collection of massive fiscal issues that have been stymied by the Washington gridlock for over two years. On the positive side, these are not new problems. They have been debated many times and a lot has been hashed out previously.

On the negative side, persistent disagreements remain. These are all politically sensitive matters, with middle grounds elusive and few details considered minor. It will entail much debate, necessarily involve negotiation and maybe even require some (dare I use the word) compromise. Can some kind of "grand bargain" be struck, or will they drive us off the fiscal cliff?

Although there are differences in viewpoint, philosophy and principle, there is a bipartisan recognition that these items must be addressed. And there is even some level of consensus on many of them. Sadly, the most probable result is that Washington policy leaders will take the approach that has been applied too many times already and choose to kick the can down the road by passing more temporary measures. But in this case that would still be far better than their other favorite practice – doing nothing. Perhaps by buying some time this go-around, policy makers can set the stage for making broad, comprehensive reforms next year. Eventually, they must take that step if they hope to avoid an even more treacherous and bigger fiscal cliff that looms somewhere on the horizon.

FISCAL ISSUES CONGRESS NEEDS TO ADDRESS

The Bush Tax Cuts
Expire, revert back to higher rates at year’s end
Current rates of 10, 15, 25, 28, 33 and 35% go back up to 15, 28, 31, 36 and 39.6 percent

Alternative Minimum Tax (AMT)
No patch in place for this tax year (2012)
Some 30 million taxpayers will pay more unless exemption amount is adjusted for inflation

Capital Gains
Revert back to higher rate at year’s end
Current rate of 15 percent goes back up to 20 percent

Qualified Dividends
Special rate expires
Current rate of 15 percent goes away, will be taxed at ordinary income rates

Estate, Gift Taxes
Revert back to higher rates and lower exclusion
Current maximum rate of 35 percent with $5M exclusion goes back up to 55 percent with only $1M exclusion

Extenders/Numerous Other Tax Provisions
Some 80 changes to deductions, credits and exclusions expire
Business examples: research and experimentation credit, $179 enhancement of the deduction for equipment. Individual examples: marriage penalty relief, child care, earned income credit

The “Doc Fix”
No extension in place
Medicare reimbursements to physicians will drop 27 percent

Federal Budget
No 2013 budget or appropriations bills have passed
Poses the threat of government shutdowns

Sequestration
The Budget Control Act of 2011 goes into effect
Will cause indiscriminant 10 percent cuts to defense and 8 percent for other non-discretionary spending

Payroll Tax Cut/Holiday
Terminates at year’s end
Rates will go back up by 2 percent

Unemployment Insurance
Extended benefits end 1/1/13
Long-term benefits scaled back when temporary benefits end

Debt Ceiling Limit
Will have to be raised by year’s end (or very early next year)
Jeopardizes credit rating and unnerves stock market

Affordable Health Care Act Taxes
Go into effect next year
Imposes 0.9 percent Medicare tax on high income individuals and a 3.8 percent Medicare contribution tax on unearned income; also a substantial new tax on medical device manufacturers

Post-election Cooperation? We Can Hope, Can’t We?

With all the negativity — political ads, public confidence in lawmakers, add your own thought here — in the air, how about some positive comments. The remarks are amazingly similar, especially coming from two people on directly opposite sides of the political aisle.

The parties are President Obama and Senate Minority Leader Mitch McConnell. Below is what they had to say in separate interviews this week. Were they simply touting what they thought the public wanted to hear (who knows) or can we at least take away a little hope that there is a realization that business as usual in Washington won’t cut it?

Decide for yourself:

  • When the president was asked how he would respond if Congress extended the Bush tax cuts — something the president opposes for higher-income earners — he offered a broader answer.

"I think it’s premature to talk about vetoes because maybe I’m a congenital optimist, but I feel as if, post-election, regardless of how it plays out, the most important message that will be sent by the American people is, we want people in Washington to act like grown-ups, cooperate, and start trying to solve problems instead of scoring political points," Obama said.

"And it is going to be important for Democrats to have a proper and appropriate sense of humility about what we can accomplish in the absence of Republican cooperation. I think it’s going to be important for Republicans to recognize that the American people aren’t simply looking for them to stand on the sidelines, they’re going to have to roll up their sleeves and get to work."

  • Anticipating a gain of Republican seats in the Senate, McConnell said: "One of the things we will have to remind newcomers and those who have supported them is that even though we will have a larger Republican Conference, we do not control the government and cannot control the government when the president holds the veto pen." He went on to say: "We need to have a humble, grateful response about this election." He even added: "Incidentally, there is no polling data that suggests [the voters] love us."