A combination of spending cuts and tax increases could bring the economy to its knees at the end of 2012. By our count, the economy must deal with nine significant fiscal events that will be automatically triggered by current law if Congress and the president take no action. Together these events create a perfect storm of contractionary tax and spending policies that could push the already fragile American economy back into recession. Fed Chair Ben Bernanke dubbed it a "fiscal cliff." The media calls it Taxmageddon.
Despite the stultifying economic effects of this government-induced uncertainty, the prospect of action anytime soon is close to nil. Congress and President Obama are gridlocked, and the coming election will only heighten tensions. The hope is that with a catastrophe looming and a tight deadline, the odds for achieving something will be slightly better when the lame-duck Congress convenes after the November 6 elections.
However, after the election Congress will be more dysfunctional than usual. Leadership is in flux. Hundreds of members are moving to new offices. Future committee assignments are unsettled. Many staff members are scrambling for new jobs. And retiring members are focused on their post-legislative careers. The most likely outcome is that the outgoing Congress will duck any major decision-making by passing a short-term extension (perhaps for three or six months) so that no major changes in law will be triggered on December 31.
Both House Budget Committee Chair Paul Ryan, R-Wis., and ranking minority member Chris Van Hollen, D-Md., have publicly stated their belief that it is unlikely that any permanent solution to the debate about fiscal policy will be struck before the end of 2012. (See "U.S. Rep Ryan Doesn't Expect Permanent Fiscal Fix in Lame-Duck Session," The Wall Street Journal, May 15, 2012.)
The lame-duck session that will conclude the 112th Congress is likely to be nothing more than the first round of a protracted, partisan, and long-overdue debate about the long-term fiscal future of the United States.
Automatic Pilot to Disaster
There is nothing simple about the plethora of issues facing Congress. Here we have broken them down into nine parts. The first five are tax breaks scheduled to expire at the end of 2012. The sixth is a set of scheduled tax increases that will take effect in 2013. These tax changes and their revenue effects are summarized in Table 1. The pending budget issues that do not directly involve taxes are automatic changes to the reimbursement rates paid to physicians by Medicare, the automatic spending cuts under the sequestration provisions approved by Congress last summer, and the debt limit. In terms of dollar amounts, the pending tax provisions are much more important than the potential spending cuts.
1. Expiration of the 2001 and 2003 Bush tax cuts and of the 2009 stimulus tax cuts. Sitting on a huge budget surplus that he feared Congress would use to increase government spending, President George W. Bush followed through on his campaign promise to cut individual tax rates in 2001. He also cut estate and gift taxes. To avoid a Senate filibuster, the tax cut was passed under the budget reconciliation process. But reconciliation rules required no deficit increases outside the 10-year budget window. And so the Bush tax cuts were enacted with an automatic sunset at the end of 2010.
To provide economic stimulus, more tax cuts were enacted in 2003. The most notable of these were the reduction in the capital gains and dividend rates to 15 percent.
In the wake of the financial crisis, Obama and a Democratic Congress enacted an economic stimulus bill that included an expansion of the earned income tax credit, an increase in the child credit from $500 to $1,000 per child, and an extension of the American opportunity tax credit. From 2008 through most of 2010, businesses were able to write off 50 percent of the cost of capital expenditures in the first year and depreciate the remaining 50 percent using normal depreciation schedules.
In December 2010, during a lame-duck session, Congress and the president agreed to extend most of the tax cuts originally enacted in 2001, 2003, and 2009 for two years until the end of 2012. Included in this law was a provision that allowed capital placed in service between September 8, 2010, and December 31, 2011, to be written off entirely in its first year. The compromise also allowed 50 percent of the cost of capital placed in service during 2012 to be written off in its first year.
Allowing all these tax cuts to expire on schedule would raise taxes by $152.7 billion in 2013.
2. Expiration of the alternative minimum tax patch. The exemption amounts and tax brackets of the individual alternative minimum tax are not indexed for inflation. That feature has converted the tax originally intended to raise revenue from a few wealthy families into a potential major new tax burden on middle-income taxpayers. Congress has passed a series of temporary adjustments to the tax over the last decade. But it has never reformed the AMT because of an unwillingness to identify offsetting tax increases or spending cuts to pay for permanent change.
Table 1. The Tax Components of the Fiscal Cliff --
Revenue Effects of Expiration of Tax Benefits (Relative to Extension) and
of Scheduled Tax Increases (billions of dollars)
Tax Provision 2013 2013-2022
2010 tax act extension of income tax provisions
originally enacted in 2001, 2003, and 2009 102.3 2,408.1
2010 tax act -- estate and gift tax provisions 4.8 432.2
Partial (50 percent) expensing of investment property 45.4 343.2
Increased and indexed alternative minimum tax
exemption amount 89.4 804.4
Interaction of extending 2010 tax act and
AMT provisions 35.3 919.7
Payroll tax cut (extended for one year) 117.9 117.9
Expired extenders in 2011
Subpart F for active financing income 5.6 81.1
Research credit 3.8 67.3
Ethanol tax credit 5.5 57.8
Depreciation of leasehold and restaurant equipment 0.4 26.3
Deduction for state and local sales taxes 1.4 18.1
Deduction for qualified education expenses 1.8 18
Look-through treatment of transactions between
related controlled foreign corporations 1 16.1
Deductible premiums for mortgage insurance 0.9 15.6
Adoption credit 0.9 11.5
American opportunity tax credit 0.7 11.4
40 other provisions expired in 2011 5.5 75
Subtotal for provisions expired in 2011 27.5 398.2
Extenders expiring at the end of 2012
Section 179 expensing 4.1 39.3
Electricity production credit for wind facilities 0.1 17.3
Exclusion of mortgage debt forgiveness 0.1 4.1
Cellulosic biofuel credit 0.1 2.4
AMT and research credits in lieu of bonus
depreciation 0 1.5
6 other provisions expiring at the end of 2012 0.2 1.9
Subtotal for provisions expiring in 2012 4.6 66.5
Tax increases in 2013 from Patient Protection and Affordable Care Act
Medicare tax expansion for incomes over
$200,000 (individuals)/$250,000 (couples) 20.5 210.2
Medical device excise tax 1.8 20
Limit flexible spending arrangements 1.5 13
Eliminate deduction for expenses allocable to
Medicare Part D 0.4 4.5
Raise medical expense deduction floor from
7.5 percent to 10 percent of AGI 0.4 15.2
Subtotal for Affordable Care Act 24.6 262.9
Total 451.8 5,753.1
Sources: Congressional Budget Office and the Joint Committee on Taxation
The last temporary adjustment expired at the end of 2011. Most of the projected 40 million taxpayers that would be affected by congressional inaction will not pay AMT until 2013 when they file their 2012 returns. Assuming the Bush tax cuts are extended, the total tax increase resulting from the absence of AMT relief would be $124.7 billion in 2013.
3. Expiration of the payroll tax holiday. The tax cut extension agreed to by Obama and Congress at the end of 2010 included a temporary rate reduction from 6.2 percent to 4.2 percent of the employee portion of the Social Security tax. In late 2011, this cut was extended to the end of February 2012. And in February 2012 it was extended until the end of December 2012. Failure to extend the payroll tax holiday would raise taxes by an estimated $117.9 billion in 2013.
4. Expiration of the extenders. Despite all the pious hand-wringing over instability in our tax laws, Congress strongly favors temporary tax breaks. They ensure that taxwriters will have a steady supply of attentive lobbyists and contributors. And it perpetually postpones the pain of paying for permanent tax relief. The list of expiring provisions has grown from a mere handful a few decades ago to more than 60 that either have expired at the end of 2011 or will expire in 2012. These provisions include the research credit, the active financing exception from anti-deferral rules for multinationals, and the deduction for state and local sales taxes. Allowing all extenders to expire at the end of 2012 would raise taxes by $32.1 billion in 2013.
5. Scheduled tax increases under the Patient Protection and Affordable Care Act. The 2010 healthcare reform package included several tax increases. Unlike the tax increases resulting from expiring tax breaks, these are entirely new. But being tax increases, they would largely affect the economy in the same way. Assuming the Supreme Court does not find the entire legislation unconstitutional -- a decision is expected in June -- these provisions could be the subject of congressional debate early in 2013 because presumptive Republican presidential nominee Mitt Romney has promised to push for their repeal if he is elected.
The biggest tax increase in the healthcare law is a new 3.8 percent tax on investment income of individuals earning more than $200,000 and couples earning more than $250,000. The new law also increases the Medicare tax rate on wages and salaries in excess of $200,000 for individuals and $250,000 for couples from 2.9 percent to 3.8 percent. Also, a new 2.3 percent excise tax will be imposed on manufacturers of medical devices. The total estimated tax increase from these provisions is $24.6 billion in 2013 and $262.9 billion over the 2013-2022 period.
6. Sequestration. With the threat of reaching the statutory debt limit just a day away, Obama signed into law the Budget Control Act of 2011 on August 2, 2011. The legislation provided that if Congress did not enact legislation that reduced the deficit by an additional $1.2 trillion over 10 years, automatic spending cuts would take place beginning in 2012. Congress failed to act. And so beginning in 2012, defense spending will be cut by $55 billion each year (about 10 percent of the defense budget), and non-defense spending will be reduced by the same amount. Social Security and Medicaid are exempt from non-defense cuts, and Medicare cuts are limited to 2 percent.
There is bipartisan agreement that the proscribed defense cuts are too large. However, there is no agreement about how to modify the 2011 legislation. On May 10 the Republican-controlled House voted 218 to 199 to modify the scheduled sequestration for 2013. All defense cuts were repealed and replaced with cuts in social programs, including food stamps and Medicaid. Sixteen Republicans and all Democrats voted against the bill. The Democratic alternative included tax increases on the major oil companies and a 30 percent minimum tax on millionaires, known as the "Buffett rule."
The House version is unlikely to be taken up by the Senate or signed by Obama.
7. Expiration of expanded unemployment compensation. The February 2012 legislation that extended the payroll tax holiday also extended unemployment insurance for the long-term unemployed through December 31. The cost of the one-year extension was $30 billion.
8. Expiration of the "doc fix." As with AMT relief for individual taxpayers, Congress has repeatedly enacted temporary relief from a scheduled reduction in Medicare reimbursements paid to physicians. The last action on this issue was in February when Congress extended the fix and prevented a 27 percent pay cut for Medicare doctors. That relief cost $20 billion. It expires December 31.
9. Debt limit. The current statutory debt ceiling on U.S. government debt is $16.394 trillion. The exact time that limit will be reached is uncertain. Current projections estimate that the debt limit will be reached sometime shortly after the new year. During last summer's intense budget negotiations, Republicans used the threat of not approving an increase in the debt limit to force Democrats to agree to cuts in government spending and the sequester contained in the Budget Control Act of 2011. In August, immediately following the passage of that law, Standard and Poor's downgraded U.S. government debt from AAA to AA+.
Playing With Fire
Democrats and Republicans are actually in agreement on a lot that they would like to see happen during a lame-duck session. Both parties agree the AMT should be patched and that most of the Bush tax cuts should be made permanent. Continuation of the payroll tax holiday is uncertain but, as was the case in February when the payroll tax cut was last extended, both parties will have a hard time opposing a large middle-income tax cut when unemployment is still high. And extension of other popular expiring provisions is not a partisan issue.
So why not act on the numerous points of agreement right now and save the relatively small subset of contentious issues for the lame-duck session? That's a deal Democrats would take in a second. And that's exactly why Republicans won't have it. The major bones of contention are extension of the Bush tax cuts for high-income households, extension of the 15 percent rate on capital gains and dividends, the extension of expanded unemployment compensation, and how the sequester should be modified (if at all). Democrats would not mind if most of those provisions expired.
House Speaker John A. Boehner, R-Ohio, has vowed to allow the House to vote on the extension of all expiring tax breaks. Like most legislative activity this year, this is a symbolic pre-election gesture that will pass the House and go no further. It is highly unlikely that Boehner would ever offer an extension of tax cuts that only included elements on which both parties agree. So any serious legislative activity will need to wait until after the election.
For many it will seem that Democrats have the upper hand going into lame-duck negotiations because it is easier for them to accept the default outcome. Inaction basically pushes us back to Clinton-era tax policy. And erasure of all the Bush-era tax policy gains would be anathema to Republicans. But the economy complicates any obstructionist strategy by the Democrats.
Under current law, taxes are scheduled to increase by about $450 billion in 2013, as shown in Table 1. Spending cuts from the sequester, reduced unemployment payments, and Medicare reimbursement cuts would add another $160 billion. That would be a massive negative stimulus that could easily put the economy into another tailspin. This is why Bernanke referred to the end of 2012 as a fiscal cliff. And many private sector economists and commentators agree that inaction would put the United States back in recession.
But the economic effects of the potential massive fiscal tightening are not as clear-cut as the economic modeling suggests. The models provide useful benchmarks, but they are not predicting the future.
The reality is the economy could suffer considerable ill effects in anticipation of the changes. Expectations are critical. If there is even a minute possibility of Armageddon-like events, it will have a detrimental effect on financial markets, business investment planning, and consumer confidence. Given the brinkmanship negotiators displayed last summer when the debt ceiling was nearly breached, no one can rule out the possibility that expiring provisions will not be extended.
At a minimum, no one can deny that the outcome of post-election fiscal policymaking is highly uncertain. That uncertainty will have a chilling effect on the economy well before the end of the calendar year, particularly if neither party is indicating a willingness to compromise. The already meager prospects of a smooth fiscal transition into 2013 were set back on May 15 when Boehner signaled that he welcomed the debt limit debate as an opportunity to force major cuts in spending and that his negotiating position will be a repeat of what he said last summer: "We should not raise the debt ceiling without spending cuts and reforms that exceed the amount of the debt limit increase." (See "G.O.P. Pledges New Standoff on Debt Limit," The New York Times, May 16, 2012.)
While the economy may suffer well before December 31 from the effects of expectations of inaction before that date, the direct effect on business and consumer cash flows and incomes may not be significant until after that date. As explained in an excellent April 26 blog post by Joseph Minarik of the Committee for Economic Development, the Treasury Department need not adjust income tax withholding on payments due after January 1, and government agencies need not cut all spending immediately if tax increases and spending cuts legally on the books are expected to be reversed. (See "Where the Budget Is Going in 2012," http://bipartisanpolicy.org/blog/2012/04/where-budget-going-2012.) Of course, any administrative softening of the fiscal blow can only be a temporary expedient. It will work only if a deal is expected soon that includes extension of most expiring provisions.
Although December 31 is a critical date, the negative effects of year-end gridlock will be transmitted to the economy gradually over a period beginning months before the end of the year and perhaps not ending until several months after the new year begins. Regardless of the timing, the size of the impact will depend on the size of the ultimate outcome and the smoothness of the process of reaching agreement. With so much at stake, as long as gridlock looms there will be a dark cloud over the economy. The only positive effect of Taxmageddon on the economy is the boost it will give to the lobbying industry. (See "'Terrified' Lobbyists Brace for Lame-Duck Chaos, Expecting Tough Tax, Budget Votes," The Hill, Apr. 26, 2012.)
Wouldn't repeal of the Bush tax cuts and other automatic fiscal tightening solve our deficit problem? No, it is too much fiscal tightening too fast. And for long-term fiscal stability we need a fiscal plan that is the result of political compromise. Yes, tax increases must be part of any realistic long-term deficit reduction program. But allowing the economy to fall off the fiscal cliff would achieve deficit reduction mostly through tax increases. That outcome is completely unacceptable to Republicans and therefore is not politically viable over the long term.
The basic two-part fiscal prescription for the U.S. economy remains the same as it has been since the dark days at the end of 2008. Notwithstanding Republican claims that the 2009 Obama stimulus was a failure, as long as joblessness remains unacceptably high and interest and inflation rates are low, deficit reduction should be postponed to prevent a collapse in aggregate demand. That means the United States should avoid tax increases and spending cuts probably until the end of 2013, and perhaps longer if Europe's financial problems persist.
Once the economy is in the clear, the desperately needed deficit reduction should take effect. The federal government's long-term finances are unsustainable. The aging of society and rising healthcare costs will push spending on social programs to unprecedented levels. Controlling Medicare, Medicaid, and Social Security spending is the key to long-term deficit reduction. Unless the country moves even further to the political right, it is inconceivable that a deal to reduce those benefits will not include tax increases. Even though spending cuts would be harmful during a recession, agreement on a credible bipartisan plan for long-term deficit reduction would produce the immediate benefits of reducing uncertainty and improving financial stability.