Fiscal Cliff 2013: What It is and Why We Want to Avoid It

Preliminary debt negotiations between President Obama, Senate leader Harry Reid (D-Nev.), and Speaker of the House John Boehner (R-Ohio), look promising but hurdles lie ahead. 

Speaking to the constructive tone of Friday’s meeting, Patrick Griffin, formerly the chief congressional lobbyist for President Bill Clinton had this to say: “It’s a fundamentally different tone … That is really a hopeful sign.” He advised caution however when trying to read too far into the cordial tone of Friday’s meeting. “[We] have to travel a long ways here to see what the four corners of the deal are.” Bloomberg writers Heidi Przybyla and Richard Rubin highlight the difficulty lawmakers will face when they attempt to translate negotiated agreements into law:

“Moving from the meeting to a deal will require consensus on the size and components of any agreement, which could require Republicans to accept tax increases they oppose and Democrats to back entitlement program cuts they don’t want. If they can come to agreement, the negotiators must then turn their concepts into legislation and advance them through Congress.”

Americans love catchy and visual phrases like “Fiscal Cliff.” But the implications of reaching this cliff are serious and too few Americans appreciate what lies ahead. Here’s a simplified explanation of the issue. At midnight on of December 31 (or January 1, if you insist) a group of revenue and spending budget changes are going to automatically take effect. Last year’s temporary payroll tax cuts will expire (a 2% increase for workers) along with certain tax breaks for small businesses. The alternative minimum tax (AMT) rates would rise for many wage earners. That’s problematic for this reason: the tax hasn’t kept pace with inflation. Let’s take a look at what this means.

Under the normal tax rules you start with your annual gross income, say $100,000. Next you subtract deductions from that number. Deductions are things like state taxes you have already paid and exemptions like mortgage interest payments or child credits. What’s important to consider here is that deductions and exemptions under normal tax rules are adjusted for inflation. So as the economy grows over time and prices rise, the “price” of your deductions and exemptions rise accordingly. Why does that matter? If in 2005 the “child credit” exemption was $1,000, then you were allowed to subtract that amount from your gross income. But if inflation increased annually for five years the “child credit” deduction would rise also. So in 2010 you would be allowed to deduct $2,000 now from your gross income! Here’s the bombshell: the AMT system does not adjust for inflation. Take a moment to think about that.

If you made $60,000 in 2005 and then adjusted your wage for inflation following five years of rising prices, it stands to reason that you might be earning $70,000. When you go to subtract deductions you find there are not only less deductions, but that the value of the deductions you can subtract haven’t kept pace with inflation. So if the “mortgage-interest” deduction was $1,000 in 2005, it will still be $1,000 in 2010. If your income continues to grow with inflation you will invariably fall into an AMT tax bracket. The good thing is that some of the AMT tax brackets are actually lower than normal tax brackets. But there’s a catch: faced with less deductions, and absent adjustments for inflation, your AMT tax rate is applied to a larger share of your income than it would be under normal tax rates.

So it often occurs that earners under AMT brackets pay more taxes in total than earners under normal tax rules. In other words, the lower AMT rates mean little if they are applied to a taxable income of $80,000 for an earner who’s taxable income under normal rules would only be $50,000 after deductions and inflation.

Back to the “Fiscal Cliff.” Along with the looming changes above, tax cuts from 2001-2003 will expire, and new taxes related to Obamacare will begin to take effect, too. Finally, a list of spending cuts agreed upon during last year’s debt talks would take effect as well. When all said and done, if a compromise isn’t reached between Democrats and Republicans, a whopping $607 billion will vanish from the economy. The Wall Street Journal put it succinctly:

“In all, according to an analysis by J.P. Morgan economist Michael Feroli, $280 billion would be pulled out of the economy by the sun setting of the Bush tax cuts; $125 million from the expiration of the Obama payroll-tax holiday; $40 million from the expiration of emergency unemployment benefits; and $98 billion from Budget Control Act spending cuts.”

That’s about 3.8% of U.S. GDP or, in simplified terms, nearly 4% of the total output of the United States of America for the entire year. That’s a shocking amount. “Fiscal Cliff” doesn’t seem to be just a catchy phrase anymore, does it? If we fall over the precipice you can guarantee that we will have another recession. Granted, today’s recovery is slow, fragile, and almost impossible to notice. But we are in a recovery.

What’s more important for me than the raw numbers is the social effect this nightmare scenario would have. Americans are exhausted and want nothing more than to put 2008 behind them. That’s a crucial point. In spite of the divisions throughout the nation between Democrats and Republicans or liberals and conservatives, all Americans are unified in their desire for financial and economic stability. They yearn for this so badly that they will literally accept any of the compromises reached between Congressional leaders. Sure, there will be some fiery rhetoric and fights after a deal is reached, but that’s the nature of American politics: the electorate will throw a fit in the morning, but at night couldn’t tell you what they had for breakfast.

So what’s the likelihood of success? Tune in tomorrow as I look at the following themes: Democrat success in the recent elections; the House of Representatives Ways and Means Committee (charged with approving or rejecting revenue proposals); and the shocking reversal of the GOP’s fortunes following the Frakenstein-esque Tea Party movement. Spoiler: success seems likely and I promise, there won’t be a lot of numbers.