The biggest agenda in American politics is the economy and one cannot search the economy on Google without the term Fiscal Cliff showing up in the results. But what exactly is the Fiscal Cliff?
Well, it’s quite simple. On January 1st, the government will reduce its spending by $1.4 trillion in cutting down on the budget. In addition, the 2001 “Bush tax cuts” are set to expire, which will lead to increased tax rates in many areas.
Economic theory dictates that reduced spending results in less money being put towards job creating government projects and effectively removes a certain chunk of the economy. In regards to the ‘other half of the cliff’, an increase in taxes will lead to a greater tax burdens on Americans. The two put together comprise the perfect storm – headed right at the U.S. economy.
In effect, the United States is cutting spending and increasing tax revenue to help decrease the record debt amassed during the Bush and Obama administrations. Overall we’re finally cutting down on our deficit spending as well. Raising revenues will help to lower our debt further.
Reduction in government spending
This whole mess started back in 2000 when government spending got out of control. The Bush administration kicked in billions for the wars in Iraq and Afghanistan. When Obama assumed office in 2008, he not only continued these wars, but increased government spending through stimulus programs and establishing ObamaCare. Over this time period, the government has spent much more than the revenue it has taken in. To remain stable, it relied on borrowing money from countries like China. In the summer of 2011, the U.S. government finally hit its borrowing limit, the ‘debt ceiling.’ What did it do to fix it? It raised the debt ceiling so they could borrow even more.
Raising the debt ceiling had its fair share of consequences. For the first time in history, the credit rating of the United States of America was downgraded by Standard and Poor from ‘AAA’ to ‘AA+’. Many credit agencies saw the rise of the debt ceiling as a sign of uncertainty in not only the economy but the in the American political system. A downgrade in the credit rating ultimately makes it tougher for our country to borrow money and fund the budget deficit. It also results in a higher interest rate imposed on loans taken out by the government.
Congress passed legislation mandating an agreement by November 2011 on a plan to cut the deficit by $1.5 Trillion. If the agreement wasn’t reached, it would automatically kick in beginning of 2013 (right when the tax cuts expire). They failed to make an agreement, so the automatic kick-in date became January 1st, 2013.
The planned reductions are $24 billion in defense spending and $40 billion in Medicaid expenses. A reduction in these areas results in less money being pumped into the economy. For example, less money being spent on defense means less business for defense contractors who in turn have to lay off employees. This may the most responsible action, but it could also have negative repercussions on the economy as well.
Now let’s look at the ‘other half’ of the cliff, the tax aspect. Back in 2001, tax rates were slashed in across the board by then President Bush. In his first term, President Obama extended the cuts until 2012 while also addition additional tax cuts for 2011 and 2012. All of these cuts are set to expire on January 1st, the same time that the government spending is set to decrease. Below is summary of the current tax cuts and what will happen on January 1st, 2013
· Ordinary Income: (income earned in the workplace) The rates on individual ordinary income will increase from 10/15/25/28/33/35% to pre-2001 rates of 15/28/31/36/39.6%,
· Capital Gain: (income from investments) The rates on long term capital gains (investments longer than one year) will increase from 0/15% to 10/20%.
· Obama-Era Tax Cuts: Many of Obama’s tax cuts to the lower class expire, the biggest ones being an in increase in the child tax
· Estate Tax: (also known as the Death Tax, a tax on passing on money to those in your will when you pass away) There is an exemption up to $5,120,000 and a top tax rate of 35%. In January this exemption will drop to $1,000,000, with a top tax rate of 55%.
· Alternative Minimum Tax: The AMT exemption is an alternative to paying ordinary income tax, basically a way to tax those who normally receive large property deductions. The exemption was previously increased from $45,000 to $74,450. In 2013, this falls back down to $45,000, ultimately allowing more taxpayers pay the AMT as opposed to the ordinary tax rates. The trouble with the AMT is it has not been adjusted for inflation; leading to more taxpayers choosing the AMT route.
· Payroll Tax: In 2011 and 2012, the employee’s portion of social security was reduced from 6.2% to 4.2%. This expires in 2013.
· Obamacare: 2013 marks the beginning of the Obamacare bill as tax rates will increase to pay for it. Those earning more than $250,000 will pay an additional 0.9% tax on their earned income and 3.8% on their unearned income (interest, dividends, capital gains.)
Ernst & Young has estimated that 710,000 jobs will be destroyed along with a .5% increase in unemployment. The tax increase will also drop after tax wages by 1.8% and the US GDP will fall 1.8%. In other words, America is headed towards another recession, a double-dip recession. The result of uncontrollable government spending has again put the nation in this unfortunate position.
Obama has repeatedly called for keeping the tax hikes for the rich who make over $250,000 while keeping the Bush tax cuts for those under that limit. Speaker of the House John Boehner has stated that he and Republicans want the tax breaks to be extended to all Americans. One possible compromise is that tax breaks would remain from those under $250,000 but there would be some limit on deductions on those making over $250,000 as well as a tighter tax code to close loopholes. This appears to be the likely scenario in place as the deadline of January 1st steadily creeps up on the United States economy.