President Obama has some crucial business to tend to, even before his second term in office commences – and it must be done with a “lame-duck” session in Congress.
Because of temporary tax cuts, previous budget deals, and procrastination in dealing with the debt, the country now faces a “fiscal cliff” with the sliding to begin on New Years Day 2013.
As the country’s feeble labor market and macroeconomy brace for the impact of higher taxes for all working households, the stakes couldn’t be higher.
The key factors are the Budget Control Act of 2011 (BCA) and the scheduled end of a handful of tax cuts. The BCA lays out automatic budget cuts to be split between military and domestic spending: $55 billion in both categories. This would result in a 9 percent cut to the Pentagon and an 8 percent cut in domestic programs—but only when compared to their regularly scheduled increases.
The tax increases would be much larger: about $500 billion overall, what the Urban Institute’s Tax Policy Center estimates to be $3,500 per household on average and $2,000 for “middle income” households.
About $156 billion of this is due to the expiration of the Bush/Obama income tax cuts—a big hit for the half of households which pay federal income taxes. Marginal tax rates would increase across the board – from 10 to 15 percent on the lowest end and 35 to 39.6 percent on the highest end. As a result, taxpayers should expect additional levies of:
- $23 billion due to the expiration of the much-debated tax cuts for incomes over $250,000.
- $25 billion from higher rates on capital gains and dividends.
- $10 billion from a drastic expansion of the estate tax – currently at 35 percent on wealth over $5.12 million, but increasing to 55 percent on wealth over just $1 million.
There are three other significant tax increases on the horizon:
- Congress will consider another band-aid for the “alternative minimum tax” (AMT)—an arbitrary limit on loopholes. If no patch is agreed upon, the AMT would expand from 5 to 25 million households, raising taxes by $3,700 on average.
- ObamaCare will add new taxes of $23 billion, mostly from a payroll tax increase on high incomes.
- Obama’s “payroll tax holiday” will expire, increasing taxes by $125 billion on all workers.
To generalize, the growth in income tax rates and AMT would hit those in the middle and upper classes hardest, while higher payroll taxes would hit the middle class and working poor.
Of course, all of these figures are estimates. We do know that higher taxes tend to reduce economic activity, harming individuals and the macroeconomy. However, we don’t know the extent to which the economy will be harmed, or how strongly people will respond to the tax hikes.
The White House’s 2013 projected revenues assume an 18 percent increase in individual income taxes and a 41 percent increase in corporate taxes. It’s unclear how much of the predicted increases are due to higher tax rates or to optimism regarding economic recovery, but it’s difficult to be optimistic about an economy that’s about to be saddled with $500 billion in tax hikes.
The problem is that we have massive deficits and rapidly growing debt. The non-partisan Congressional Budget Office says that we need “fundamental” reform. The White House estimates that revenues will only cover interest on the debt and “entitlement” spending in 2012. All other functions of government are being financed through borrowing.
Continuing down this path will lead to bankruptcy.
Though we’re speeding toward a “debt cliff,” fixing the problem will be painful. To reduce deficits, we need reduced spending and/or higher tax revenues (not necessarily the same as higher tax rates). We know that significantly higher tax rates are not the answer since economic activity will stagnate as a result.
Beyond that, your policy preferences will depend on your ability to grasp the subtle costs of tax increases compared to the more obvious costs of cutting spending programs – and your confidence in the government’s ability to spend money better than the private sector.
-Dr. Eric Schansberg is a professor of economics at Indiana University Southeast, and a member of the Bluegrass Institute Board of Scholars