Beyond the Rates: Navigating the Fiscal Cliff

Income tax rates are getting the headlines, but the payroll tax hike would be the real killer.

   

Sick of the phrase “fiscal cliff” yet? Well, me too — but it still matters. And the issue that everyday citizens should care about isn’t even getting any press.

As we read the tea leaves this week, all signs are pointing to no significant deal between President Obama and House Republicans that would forestall a trip over the cliff on Jan. 1. Although there are some signs of Republican acknowledgement that rates will have to rise (and limiting deductions won’t be enough to satisfy Obama), the president himself has upped the ante by insisting that any deal on the fiscal cliff include essentially doing away with the debt ceiling. The president also included $200 billion of additional stimulus in his proposal that actually made some Republicans laugh.

What does this mean for Republicans? They have an extremely bitter pill to swallow if they choose to compromise with Obama. They will be raising taxes on the wealthy, appearing to concede on the debt and handicapping themselves in future negotiations. While the GOP is clearly bruised from its electoral defeat this year, it does not yet appear weakened to the point of concession on all three of these measures.

While most of the chatter has been over whether John Boehner and his GOP House caucus will cave on keeping the Bush tax cuts for the top 2% of households, the fiscal cliff is a much more daunting and complex edifice than a simple structure of graduated income tax rates. As the top political operatives exchange phone calls and issue talking points, let’s speculate about the consequences of “no deal” on tax rates and examine the other elements of the cliff — payroll taxes, jobless benefits, payments to Medicare providers to name a few.

The Headline Issue — Income Taxes

At the end of this year, tax rates are scheduled to return to their Clintonian levels for all Americans, payroll taxes will rise, tax credits will expire, deductions will be limited and the Alternative Minimum Tax will take a bite out of even more households. All of these forces together equal an average tax hike of about $3,500 per household.

If Obama and Boehner do not come to an agreement in the next week, we will all see significantly lower paychecks in January. Americans will feel the pinch pretty quickly and the GOP will find itself somewhat desperate to get a deal on taxes done as soon as possible. Politically, this may be beneficial to the Republican Party. They will blame Obama for allowing all taxes to rise and then claim credit for cutting taxes.

Whether the public will believe that story is anyone’s guess. Right now it appears that Americans are prepared to blame the GOP for not getting a deal — 53% of respondents in the latest Pew Poll say the Republicans will be most at fault for a stalemate.

Under this scenario the Democrats will also claim victory. Obama will rightly be able to claim that he held fast to his conviction and electoral promise that the rich need to pay more. He will be negotiating for a broad middle-class tax cut from a position of strength.

Room for Compromise This Year

While the headlines would have you believe that fixing the fiscal cliff is an all-or-nothing proposition, that’s simply not true. Some of the looming problems we face could be patched in pieces. I expect the two parties to come to an agreement about at least two things this year.

The Alternative Minimum Tax: The AMT is a longstanding tax that was intended to prevent high earners from claiming so many deductions that they avoid paying taxes. Because it has never been indexed for inflation, every year more and more middle-income taxpayers would technically be subject to it. So, every year or so, Congress has passed a temporary “patch” or “fix” to the AMT.

As negotiations proceed this year, we can expect yet another temporary fix to the AMT to pass even this deadlocked Congress. This legislation has always been bipartisan … and no one stands to gain from its expiration this year.

The doc fix: Like the AMT, periodically increasing Medicare reimbursement rates to providers — i.e., doctors and hospitals — has been a longstanding bipartisan exercise. This is important to seniors because doctors will likely start refusing Medicare patients if they are not adequately compensated. Again, neither party would benefit if seniors woke up in 2013 to find that their doctors would no longer provide them care.

Obama included an extension of the doc fix in his proposal, and I expect the GOP will pass some version of it.

What Really Matters

Obama has proposed extending for another year the payroll tax cut and jobless benefits for the long-term unemployed. But these items are less likely to be resolved before Dec. 31. The GOP has shown no stomach for these two expenditures, and I suspect they will be left on the cutting room floor as the fight over marginal tax rates heats up.

Ironically perhaps, the expiration of these two bits of stimuli will have the most immediate negative effects on consumer spending.

Payroll taxes are one of the most regressive aspects of the tax code. Although the two-year reduction in payroll taxes that American workers have enjoyed was always meant to be temporary, restoration would feel like a tax hike to everyone — particularly those in the lowest income brackets. The average worker will take home $1,000 less next year.

Continuing benefits to the long-term jobless have also been part of the economic reality over the past three years. Cutting off monies to the jobless while the labor market is still weak will shrink consumer spending.

While the markets seem to be assuming that we will come to some sort of compromise on tax rates in the near future, it does not appear to be factoring in the hit that consumer spending is likely to take. While I don’t see anyone making a strong case for jobless benefits, some Democrats are beginning to highlight the importance of extending the payroll tax cut. The JEC release a report last week detailing the positive effects the cut has had on consumer spending and job creation. The business community and investors should hope this tax cut remains — the rates of the top 2% are far less important.


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