Can a deeply divided United States Congress, in an election year, pull the iron out of the fire and agree on a key tax and spending bill that will save America from toppling over the so-called ‘fiscal cliff’ next year?
January 1, 2013, the date that the US reaches the fiscal cliff, is so described because this is when a plethora of temporary tax cuts, tax credits and other tax breaks are due to expire, and more than USD1 trillion in spending cuts will automatically kick in, in a dual shock to the already fragile US economy. Unless, of course, Congress can agree on a new ‘tax extenders’ package before the end of the year.
The possible tax increases include, not only the expiry of the ‘Bush tax cuts’, the Alternative Minimum Tax ‘patch’ and the payroll tax reduction, but also a halving of the child tax credit and a return of estate tax to 2001 levels. Furthermore due to the failure of the bipartisan deficit reduction committee to reach any sort of agreement last year, automatic spending cuts of USD1.2 trillion are also scheduled to be imposed.
Give the absence of bipartisanship on Capitol Hill since the last mid-term elections, the chances of any sort of agreement on tax now looks remote. However, in essence, this is an issue that boils down to whether the Republicans, who control the House of Representatives, will be prepared to agree to President Obama’s demands that taxes should rise for the wealthy (defined by the President as a household making more than USD250,000 per year), or whether the Democrats, in turn, will cede some ground by allowing some of their more cherished spending programmes to be cut while accepting that any sort of income tax hike is just not feasible with the GOP controlling the House of Representatives.
Last year, Congress went down to the wire on just this issue when the federal government neared its statutory debt limit, prompting fears of a government ‘shutdown’. And previous to this, the 2010 ‘tax extenders’ bill was not actually passed by Congress until well into 2011, meaning that many of these temporary tax cuts had expired before they were renewed again. The omens, then, are not good.
With the prospect of a further stand-off between the Democrat and Republican parties later this year over the debt limit, House of Representatives Speaker John Boehner (R - Ohio) has returned to his mantra of spending cuts with no tax increases.
In his address to the Peter G. Peterson Foundation’s 2012 Fiscal Summit in May, Boehner renewed his commitment to the principle that any increase in the nation’s debt limit must be accompanied by spending cuts larger than the amount of the debt limit hike.
He pointed to a current “rebellion against overspending, over-taxation, and overregulation” in the US, and, despite everybody’s focus on the elections in November this year, to the fiscal cliff. That, he said, is a date that “looms large" for every household and every business. "On that day, without action by Congress, a sudden and massive tax increase will be imposed on every American – by an average of USD3,000 per household. (Income tax) rates go up, the child tax credit is cut in half, the Alternative Minimum Tax patches end, the estate tax returns to 2001 levels, and so on,” he warned.
However, he also added that, on January 1, 2013, there could also be “indiscriminate” spending cuts and tax increases from the health care law, while, sometime after the elections, the federal government will again near its statutory debt limit.
This end-of-the-year fiscal cliff, Boehner said, is a chance for the US “to bid farewell – permanently – to the era of so-called ‘timely, temporary, and targeted’ short-term government intervention. We have to avoid the fiscal cliff, but we need to start today.”
In his opinion, the debt limit exists in statute precisely so that government is forced to address its fiscal issues. When the time comes, he confirmed that he “will again insist on my simple principle of cuts and reforms greater than the debt limit increase. This is the only avenue I see right now to force the elected leadership of this country to solve our structural fiscal imbalance.”
But he confirmed that what also doesn’t count as ‘cuts and reforms’ are tax increases. "Tax hikes destroy jobs – especially an increase on the magnitude set for January 1,” he cautioned. Instead he called for Congress to begin working on broad-based tax reform that lowers rates for individuals and businesses while closing deductions, credits, and special carve-outs, across all of the tax code, personal and corporate.
That is why, he concluded, an upcoming Republican bill in the House (before the elections), to stop the impending tax increase, will also establish an expedited process by which Congress would enact real tax reform in 2013, and whereby a timeline would be put in place for action to be taken.
“The House Ways and Means Committee will work out the details, but the bottom line is: if we do this right, we will never again have to deal with the uncertainty of expiring tax rates. We’ll have replaced the broken status quo with a tax code that maintains progressivity, taxes income once, and creates a fairer, simpler code.”
In a letter to the United States Senate Majority Leader, Harry Reid (D – Nevada) later that month, 41 Republican Senators, led by Ranking Member of the Finance Committee Orrin Hatch (R -Utah), and Republican Leader Mitch McConnell (R - Kentucky) urged him to take immediate action to “stop the largest tax increase in history”, on January 1.
“If Congress and the President do not act by the end of this year, American taxpayers will face USD310bn in tax increases next year. This would be, without any exaggeration, the largest tax increase in American history,” the Republican Senators wrote. “The failure to extend the expiring tax relief - tax relief previously supported by President Obama - would hit all taxpayers, undermine small businesses, and be a dangerous drag on the economy.”
The Senators professed themselves still to be “deeply concerned about the nation’s fiscal health” and about the adverse impact the tax increases would have on economic growth, with the economy being put back into a recession. “The impact of this fiscal cliff might actually be understated,” they added. “Billions in new taxes on capital that were enacted as part of the President’s health care law come online in 2013, and they will almost certainly dampen economic growth even further.”
In their opinion, instead of addressing this fiscal cliff, President Obama and Congress have spent much of the past year “advancing misguided redistributionist policies in the name of fairness”.
“The opportunities that will come to individuals and families - to purchase a home, send a child to college, or start a business - as a result of economic growth far outweigh those that come from efforts by Washington politicians to redistribute wealth in the name of fairness,” they wrote, concluding that these policies make the looming fiscal cliff "utterly predictable".
"It is essential that Congress and the President address these coming tax increases this summer, rather than creating additional uncertainty for families and job creators by waiting until the last possible minute,” the Senators urged.
Members of the GOP also point to the harm that Obama’s tax proposals will do to small businesses as well as individuals. Orrin Hatch (R – Utah), the Senate Finance Committee’s Ranking Member, has released an analysis by the Joint Committee on Taxation (JCT) that found that the amount of flow-through unincorporated business income that would be subject to a tax increase from the President’s proposal to allow the Bush tax cuts to expire for households earning more USD250,000 per year, has increased from 50% in 2011 to 53% in 2013. The number of businesses subject to the individual income tax increase would also go up from under 750,000 in 2011 to approximately 940,000 in 2013.
In its findings, the JCT estimates that, in 2013, 53% of those taxpayers with approximately USD1.3 trillion of aggregate net positive business income will have marginal rates of between 36% and 39.6% under the President’s proposal.
“This independent analysis is further irrefutable proof of why we simply cannot allow the President to have his way by raising taxes on small business,” added Hatch. “With our economy as weak as it is, it makes absolutely no sense to hit more and more small businesses with a tax hike. Let’s stop the looming massive tax increases that are set to hit nearly every tax-paying American on January 1, and move forward together to reform the tax code in a manner that spurs economic growth.”
The Obama Administration however has always refuted the suggestion that small firms will be worse off if income tax cuts are allowed to expire for high income households, and in a ‘let’s get the facts straight on tax’ entry on the White House blog in early June, it was noted that such firms "are predominately millionaires and billionaires, corporate law partners, [and] hedge fund managers”. It was argued that over half of the 400 highest earners in the United States would be 'small businesses' under the Republican definition of the term.
According to the White House, the so-called 'middle class tax cuts' debate revolves around a simple choice: "We can either make investments in education, transportation, and new sources of energy – the types of investments that have always been essential to America’s businesses and to creating good middle class jobs. Or we can cut taxes even more for wealthy Americans who don’t need them and didn’t ask for them."
By being so obstinate and insisting that no deal could possibly take place if even one cent was raised in new taxation, the Democrats are accusing the Republicans of effectively holding the economy hostage with their refusal to compromise. As Chris Van Hollen (D – Maryland), the Ranking Member of the House Budget Committee put it: “once again, Republicans are playing chicken with our economy and manufacturing an unnecessary crisis. The GOP’s refusal to consider both spending and revenues – despite the recommendation of every bipartisan group that has looked at this issue – does nothing to bring us any closer to getting our fiscal house in order. Their insistence on protecting tax breaks for millionaires and special interests above all else won’t boost economic growth, reduce the deficit, or move our country forward.”
Despite the stand-off, doing nothing is clearly not an option, and fears that failure to deal with the fiscal cliff could tip the US back into recession are not unfounded, with the Congressional Budget Office (CBO) having warned that current law will dampen economic growth in the short-term.
The CBO estimates that the combination of policies under current law will reduce the federal budget deficit by USD607bn, or 4% of gross domestic product (GDP), between fiscal years 2012 and 2013. The resulting weakening of the economy will lower taxable incomes and raise unemployment, generating a reduction in tax revenues and an increase in spending on such items as unemployment insurance. With that economic feedback incorporated, it projects that the deficit will drop by USD560bn between the two years.
Under those fiscal conditions, which will occur under current law, the CBO expects the growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5%, with the economy projected to contract at an annual rate of 1.3% in the first half of the year and expand at an annual rate of 2.3% in the second half. Such a contraction in output in the first half of 2013, it says, “would probably be judged to be a recession”.
On the other hand, if lawmakers changed fiscal policy in late 2012 to remove or offset all of the currently scheduled policies, the CBO estimates that the growth of real GDP in calendar year 2013 would be around 4.4%, well above the 0.5% projected for 2013 under current law.
However, the CBO also concludes that eliminating or reducing the fiscal restraint scheduled to occur next year without imposing comparable restraint in future years would reduce output and income in the longer-run relative to what would occur if the scheduled fiscal restraint remained in place, and federal debt would continue to rise much faster than GDP.
That, it says, could not be sustained indefinitely, and policy changes would be required at some point. It points out that: “The more that debt increased before policies were changed, the greater would be the negative consequences - for the nation’s future output and income, for the burden imposed by interest payments on the federal debt, for policymakers’ ability to use tax and spending policies to respond to unexpected challenges, and for the likelihood of a sudden fiscal crisis - and the more drastic the ultimate changes in policy would need to be”.
The CBO therefore suggests that, if policymakers wanted to minimize the short-run costs of narrowing the deficit very quickly while also minimizing the longer-run costs of allowing large deficits to persist, they could enact a combination of policies - changes in taxes and spending that would widen the deficit in 2013 relative to what would occur under current law - but that would reduce deficits later in the decade relative to what would occur if current policies were extended for a prolonged period.
At a June hearing of the Senate Finance Committee to examine how the United States could avoid the year-end fiscal cliff, its Chairman Max Baucus (D – Montana) called on Congress to work to avoid the economic harm the fiscal crisis would cause. However he warned that cancelling the automatic spending cuts and extending all the expiring tax cuts would demonstrate a dangerous inability to solve the deficit problem. A combination of additional revenues and spending cuts, he argued, is the only solution.
“With the fiscal crisis we’re facing at the end of the year, Congress needs to come together and agree on a combination of revenues and spending cuts. It’s the only way forward,” he stated. “Alternatively, cancelling the sequester and extending all of the expiring tax cuts would tell the American people and the world that we are not serious about our deficit problem. This is an opportunity for us to come together to pass a balanced solution that puts us on a sustainable path for the future.”
At the hearing, Baucus described his criteria for a deficit reduction plan that needs to be balanced, comprehensive and fair, and that brings in more revenue than current policy to pay for the country's needs. He added that the plan should start by stabilizing debt as a percentage of gross domestic product (GDP), and reduce it thereafter. Baucus also said that the plan should avoid deep, immediate cuts that would shock the economy in the short-term.
Dr Alice Rivlin and Senator Pete Domenici (R – New Mexico) from the Bipartisan Policy Center’s Debt Reduction Task Force agreed that, in addition to reining in spending, reducing US debt levels will require raising additional revenue. They pointed out that, under current policies, the Congressional Budget Office projects revenue to average only 18% of gross domestic product (GDP) over the next decade, but that the last time the US budget was balanced, from 1998-2001, revenues averaged 20% of GDP.
They also believed that without fundamental reform of the tax code, America cannot avoid continuing the steady increase of its federal debt toward 100% of GDP in the next decade and 200% of GDP a decade later. “These are clearly unsustainable levels,” they said, “and normally associated with serious economic and financial difficulties for any nation that strays so far from fiscal responsibility.”
Beyond the Washington bubble however, it is easy to forget that the real victims of the Congressional infighting will be ordinary US taxpayers, who face yet another year of uncertainty as they contemplate filling out their next tax returns. As the United States National Taxpayer Advocate Nina E. Olson observed in her latest annual report to Congress, released June 27: “The continual enactment of significant tax law and extender provisions late in the year has led to IRS delays in handling millions of taxpayers’ returns and caused many taxpayers to under-claim benefits because they did not know what the law was”.
"The 2013 filing season is likely to pose problems for many (if not most) taxpayers and the IRS, if Congress does not address the many provisions that have already expired or soon will,” Olson warned, before going on to observe that: “An aura of uncertainty prevails as the IRS and taxpayers wait for word about what will be the law governing us this year and for the near future. This uncertainty affects the IRS’s ability to smoothly administer the filing season and taxpayers’ ability to make plans.”
But with Congress preoccupied with a political slanging match, and as divided as ever, the plight of taxpayers looks to have been forgotten. And with both sides on the face of it so reluctant to compromise on tax and spending, it looks like we could be headed for another round of frantic last minute law-making. Nothing much new or different, then!
IMPORTANT NOTICE: Wolters Kluwer TAA Limited has taken reasonable care in sourcing and presenting the information contained on this site, but accepts no responsibility for any financial or other loss or damage that may result from its use. In particular, users of the site are advised to take appropriate professional advice before committing themselves to involvement in offshore jurisdictions, offshore trusts or offshore investments.
All rights reserved. © 2013 Wolters Kluwer