Cocktails On the Edge of the Fiscal Cliff

So we are fully in the midst of the presidential debates, and that means the elections are just around the corner.  If you caught the first debate on October 3, you may have noticed a more spirited Romney than usual and a more subdued Obama.  October 11 will feature the Vice Presidential candidates hashing out the issues.  Then two more presidential debates will follow, on October 16 and the 22nd.

But even as we root for our favorite candidate, it can sometimes be challenging to keep up with the lingo. One phrase in particular that has become popular not only with the candidates but with analysts, pundits, economists and the media is “the fiscal cliff,” used to describe a series of possible tax increases that may push the US towards another recession.  Let’s break it down.

What Is The Fiscal Cliff?

This is a phrase used to characterize the mixture of tax increases and spending cuts that are scheduled to occur after December 31, 2012.  In general, the fiscal cliff refers to 3 dilemmas: whether to keep tax rates low or allow current tax laws to expire;  whether Congress will/can do anything about the deep mandatory spending cuts to be instituted in 2013; and whether Congress will extend the payroll tax holiday and other tax incentives set to expire after December 31, 2012. 

I like this cliff more than the fiscal cliff.

Did you fall asleep yet?  If so, WAKE UP!  THIS IS IMPORTANT!!! 

The Bush Tax Cuts

Let’s go back in time to 2001: After the tech bubble burst and post-9/11, we were in the midst of a recession. To encourage consumer spending and boost the economy, President Bush initiated legislation that lowered tax rates on income and investments.  The legislation also affected estate planning, lowering the tax rates on estates, gift tax and generation skipping transfer taxes, and increasing the exemptions.  There were also some personal exemptions and deductions thrown in.

However, these laws were set to expire at the end of 2010 (meaning that on January 1, 2011,  tax rates would go back up to the 2001 rates).  In 2010, President Obama wanted to let the tax cuts expire (and thus increase taxes) only on the wealthy, but he was persuaded by his advisors to extend the tax cuts for everyone at least until the economy starts to recover.  Thus, the Tax Bill of 2010 was passed, extending the Bush tax cuts and keeping tax rates low–but only for two years. 

So here we are in October 2012 and this means we are coming to another tax deadline– and fast.   If no legislation is passed to extend the tax cuts for another year or to make them permanent–tax rates will go up on everyone on January 1, 2013, just 2 1/2 short months away.

Of course, controversy is brimming between the parties on whether to extend the tax cuts, make them permanent, let them expire on January 1 or only let them expire on the wealthy (as President Obama wants).  Romney wants to go a step further and lower tax rates across the board by 20%.

The candidates

[For those families lucky enough to make $250,000 a year, there will be additional taxes on investment income and salary income imposed in 2013, thanks to the Affordable Care Act (the health care act passed in 2009).  An additional tax of 3.8% will be added to your investment tax for any investment income over $250,000; and you’ll pay an additional 0.9% tax on your income over the $250,000 threshold.  Kinda makes you miss the good lo’ days working at Dairy Queen, huh?]

BUT THAT’S NOT ALL….

The Budget Control Act and The Sequester

The fiscal cliff also  refers to the automatic spending cuts resulting from the debt ceiling debacle that occurred last year.  Bear with me….

Back in the summer of 2011 when some of us were playing bocce ball on the beach, Congress was at work trying to deal with the debt ceiling.   Unlike the deficit, which is, in general, the amount of money the US government needs to borrow to make ends meet during its fiscal year, the debt is an accumulation of all US annual deficits.  It’s like racking up credit card debt and letting it accumulate year after year without paying it all off.

Reaching the debt ceiling is like reaching your limit on your credit card-to increase the limit you have to call your credit card company and prove your credit-worthiness for the company to extend more credit to you. When it comes to the debt ceiling–or the maximum level the debt can reach– Congress has to pass legislation to raise the ceiling so the government can continue borrowing.  Usually it’s the President’s job to go before Congress and explain why the ceiling must be lifted.

In past years, Congress raised the debt ceiling without controversy.  Last year, however, when President Obama went before Congress to ask for the ceiling to be raised, it was MAJOR DRAMA.  At that point, we were still in the midst of a sluggish recovery, the unemployment rate was still over 9%, the housing market was still a mess and the government had already passed several spending packages over the past few years that had caused the deficit to reach past $1 trillion, the highest its been since World War II.  It was a hard sell for President Obama to make to a very divided Congress to increase the debt limit.  On the other hand, failure to raise the ceiling could have resulted in serious consequences to our economy: services would have been drastically cut and the country’s credit rating would have been lowered (which it was anyways by S & P).

It’s a bird! It’s a plane! It’s the Supercommittee!

To deal with the issue, Congress put together a “Supercommittee” whose primary job was to deal with the growing deficit and find ways to raise revenue ( increase taxes) and identify areas to cut spending (curtail government spending).  They passed the Budget Control Act that summer, allowing the debt ceiling to be raised, and making general pronouncements about future measures to curb the deficit (to be decided after the bill was passed).  They also added a “sequester” in case both sides couldn’t agree to a series of spending cuts and tax increases.  The sequester is a package of automatic spending cuts that would be  enforced if the parties were unable to come to an agreement on how to curb the debt.

The cuts included in the sequester are pretty hard-core; lawmakers put them in there with the intention of scaring the committee into action and forcing them to make the tough decisions on reducing the deficit.  The sequester includes major cuts to the defense budget, along with cuts to social services, education and health care, among others.  When the Budget Control Act was passed, many in Washington were confident that the committee could come to an agreement, however grudgingly, that the rights cuts would be made, and that the sequester would not need to be enforced. 

But here we are today and GUESS WHAT? Neither party was able to come to an agreement on how to curb the budget, cut spending and raise revenue.  This means that come 2013, there may be some major changes made to our military and defense, education and other services we’ve come to expect.

Taxes, Your Holiday Is Over!

Even better than a tax holiday!

WE’RE AT THE HOME STRETCH.  I’LL MAKE THIS ONE SHORT AND SWEET!

The third and last major component of the fiscal cliff are the additional tax extensions for the middle class expiring after 2012.  When the Tax Bill of 2010 was passed, it included a provision that reduced the Social Security taxes that we have to pay by 2%–AKA the tax holiday.  This pans out to keeping about $20 in your pocket on a weekly basis if you make $50,000 a year.  Congress decided to kick this into the Bill as a way to keep more money in the pockets of Americans and encouraging us to spend more.  Of course, $20 a week in savings is barely enough for a family of four to dine at Chez McDonald’s, but that was exactly the purpose. Many of us unknowingly used that $20 on gas, beer, diapers, etc.

The Tax Bill also extended tax savings that middle class families have enjoyed over the years, increasing tax savings for families with children, providing education subsidies, and eliminating the AMT on the middle class.  All of these provisions, along with the tax holiday and tax cuts on income and investments are set to expire after midnight on December 31, 2012.

So taken together, it looks like–if nothing is done to change this–we are headed for major tax increases in 2013. Some analysts claim that if all of these tax incentives expire and the tax rates go back up, the average family will see a tax increase of $1700.  Under normal circumstances, a tax increase is a big fat buzzkill.  But in a sluggish economy, with slow growth, a fluctuating market, a stubbornly high unemployment rate and rampant uncertainty, many economists agree that an increase in taxes could push the shaky economy off the cliff– and back into the trenches of a recession.

On the other hand, with a sky-high deficit (last year the government borrowed about $1.3 trillion), an expanding middle class and entitlement programs like Medicare and Social Security on an unsustainable path, many argue that tax hikes are inevitable and necessary.

Either way you slice it, we are on a tough economic path and the road to recovery will be painful.  Let’s keep these issues in mind as we watch the debates and head towards the elections.