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Fiscal Cliff Definition: Why Your Taxes Could Rise By Several Percent If Nothing is Done

Editor's Note: This is a partner article to Mark's GIF guide to the fiscal cliff. Be sure to click over for a more light-hearted look at the next congressional crisis.

The election may be over, but the political fight in Washington is just getting started. The lame duck session of the 112th Congress reconvenes this week with the much discussed “fiscal cliff” squarely at the top of the agenda. Without a doubt, you can expect talk of Congress’ next big fiscal crisis to dominate press coverage for the next two months.

To better prepare you for the coming media flood of punditry and commentary, here’s a quick primer on how we got here and what we’re dealing with.

What is the “fiscal cliff” and why does it matter?

The “fiscal cliff” has become the popular term to describe a series of laws expected to expire or take effect at the end of 2012. The biggest ticket issues on Congress’ agenda are determining whether to extend the payroll and Bush tax cuts, as well as deciding whether to repeal the Budget Control Act of 2011, which imposes a mandatory sequester for discretionary and defense spending (more on this later).

If nothing is done and the laws expire and become enacted as scheduled, tax rates will increase significantly for all income-levels and the government will be forced to implement $1.5 trillion in cuts over the next 10 years.

We’ve been in similarly tense legislative situations before but this year’s crisis is somewhat unique due to the context. For starters, the economy is far from stable. Both Congress and the president understand that failing to come to a compromise risks throwing the economic recovery into reverse. Hiking taxes while slashing government spending could destroy millions of jobs while tanking our GDP’s growth rate – two results that could plunge us back into recession.

Second, the partisan rancor in Congress is much worse than it has ever been. Coming off last year’s debt ceiling fight and failure to come to any sort of grand bargain on taxes and spending, the two sides in Congress are worryingly polarized heading into the final months of the year. Coming to an agreement is going to take compromise and we simply don’t know if either side is willing to play ball yet. Party leaders have expressed flexibility, but they've done that before. We'll just have to wait and see whether they mean it this time.

Skip the fancy jargon and political nonsense, will my taxes go up?

If nothing is done? Absolutely. The expiration of the Bush Tax cuts, coupled with the expiration of the payroll tax break, would raise taxes on all Americans by several percentage points.

That said, nothing is set in stone. President Obama has expressed that he wishes to extend the Bush Tax Cuts for all but the highest income earners. For their part, the Republicans are still keeping lock-step with their pledge not to raise any taxes and oppose any tax rate increases, even if due to the expiration of tax cuts.

In other words, neither party wants to raise taxes across the board. Whether the two sides can come to some sort of agreement will determine who, if anyone, gets hit by tax hikes.

What on Earth is “sequestration?”

It’s a big word that D.C. wonks like to use to make themselves sound smart. 

In this context, sequestration is the mandatory implementation of budget cuts agreed to in 2011. You may remember last year’s much discussed Super Committee. The committee was formed to find compromise and a bi-partisan way forward on budget issues. In order to motivate the members to come to some form of agreement, the Congress agreed to hang an anvil over its head in the form of $1.5 trillion in cuts that would be automatically enacted if the Super Committee failed to find some common ground. Needless to say, the Super Committee failed to come to an agreement and the resulting automatic cuts, scheduled to go into effect on January 1, 2013, are what everyone is calling “sequestration.”

The mandatory cuts will affect both discretionary and mandatory spending between 2013 and 2021. The cuts will equally impact security (defense) and non-security programs. The only exempted areas were Social Security, Medicaid, civil, and military employee pay, and veterans benefits.

***An important footnote: the cuts to be implemented by the seuqester are cuts to the rate of growth of spending. Even if the sequester is implemented, government spending will still increase over the next 10 years. The rate at which it increases will be reduced but the government's budget will not be decreasing. This is primarily due to increased costs due to inflation, as well as exponentially increasing costs in healthcare, something not addressed by the sequester.

How did we get into this situation?

You know how pundits always accuse Congress of “kicking the can down the road” instead of coming to some form of agreement? Well, we’ve reached the place where several of the biggest cans have landed.

Due to the partisan vitriol dominating Congress under President Obama, little has gotten done. There has been no budget passed in over 1,000 days, primarily due to Republican obstruction in the Senate. The election of a Republican House in 2010 made any form of bi-partisan compromise even more difficult. The Tea Party wing of the GOP refused to discuss any budget agreements that increased spending while the Democrats in the Senate refused to vote on any House bills intended to gut many government agencies or entitlement programs.

As a result, the government has been funded by a series of stop-gap measures and temporary extensions for several years. These have been joined by temporary extensions of the Bush Tax Cuts and the payroll tax cuts in 2010 and 2011. Finally, the sequester discussed above was added to the list, with the same "expiration date" as all of the other legislation.

Part of the reason everything is coming to a head together is probably intentional. By bringing a variety of issues concerning the country’s fiscal future into the conversation simultaneously, the odds of a “grand bargain” rise dramatically. It’s arguably always preferable to expend the political capital to address everything in one go rather than ten times over the course of a year.

What are the possible solutions? How likely is Congress to reach a compromise?

There are a number of potential outcomes that run the spectrum from doing nothing to repealing everything.

As I discussed above, it’s unlikely that Congress or the president will sit on their collective hands. The economic risk and massive impact of doing nothing will force some form of action. However, if the two sides fail to find some common ground, doing nothing is always a potential outcome.

On the other end of the spectrum, Congress could also “undo” all of these actions – extending the Bush and payroll tax cuts and repealing the sequester. This would leave the status quo pretty much as is. This is equally unlikely because both sides agree that there need to be some cuts to government to make it more efficient and to reduce wasteful spending. The fight comes over what to cut and whether to raise taxes on high income earners to help offset those cuts.

As you can see in the chart above (courtesy of the Congressional Budget Office), undoing the entirety of the “fiscal cliff” would have tremendous repercussions for our ballooning debt. The blue “Baseline Projection” indicates what will happen if Congress does nothing. The “Alternative Fiscal Scenario” will be the state of our debt if Congress extends the Bush Tax cuts and repeals the mandatory sequester.

Congress could also collectively kick the can again and let the next Congress deal with this problem. But this is unlikely for two reasons. First, Obama has promised to veto any extension of Bush tax cuts for the highest earners. Second, Republicans are in a weaker position in the 113th Congress – their failure to pick up the Senate, coupled with big losses in the House, leaves the Republicans with far less wiggle room in 2013. House Speaker Boehner (R-Ohio) and Senate Minority Leader McConnell (R-Ky.) understand this and will likely try to get the most out of the Congress they have now rather than risk fighting this fight next year.

The final, and most likely outcome, is some form of compromise that will see revisions in the tax code, the extension or elimination of certain tax cuts, and a targeted repeal of the mandatory budget cuts. The result will be smaller cuts in spending than originally intended but may also include potentially promising tax reforms. Don’t be surprised if Congress passes some reform while setting a date for the next Congress to do mandatory follow-up.

What to watch for in the coming months

Expect the conversation to get much more heated as Congress starts tossing ideas around. Reports that several bipartisan groups of senators and congressmen are already working on potential deals show that at least some folks in Congress are setting aside their differences to come up with a solution. Expect the rhetoric to become aggressive as soon as potential solutions are made public.

The real variable in all of this is whether the two sides are able to come together. More specifically, it will depend on whether Speaker Boehner can control the more extreme elements of his party in the House and whether Minority Leader McConnell can keep feisty young Senators like Rand Paul (R-Ky.) from filibustering potential compromise legislation.

Although the Republican strategy of rigid opposition to prevent a second Obama term is no longer relevant, it appears too early to tell whether the GOP will collectively change their minds on obstruction. After receiving a thorough shellacking last Tuesday, Republicans will have to reconsider whether stonewalling is a winning political strategy. Cracks are beginning to show amongst the Republican leadership but drawing conclusions before any potential legislation is on the table is premature.

Any potential solution will have to win bi-partisan support to reach the president’s pen. The question now is whether Democrats and Republicans can come together to address America’s own austerity crisis and determine whether they will help or hinder our economic recovery heading in to the new year. 

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