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Fiscal Cliff, Taxmageddon, Sequestration – What Does It All Mean?
Now that the election is over, the President, the U.S. Congress, the media, and the financial markets have shifted their attention to the impending economic calamity that Congress created and that Congress must fix—otherwise the country will tumble off the “fiscal cliff.”
“Fiscal cliff” is the new buzzword being used to describe the situation that the U.S. will face at the end of this year when several tax policies are set to expire, new taxes from the Affordable Care Act will kick in, and provisions of the Budget Control Act of 2011 will go into effect. If no action is taken by Congress and the President during the lame duck session, $500 billion of spending cuts and tax increases will automatically occur.
Both sides of the aisle worry that the fiscal cliff—including “taxmageddon”—could plunge the U.S. back into a deep recession. The bipartisan Tax Policy Center estimates that if no deal is struck by January 1, 2013, 90 percent of Americans would face tax increases, at an average of $3,500 in additional taxes by April 2013.*
In 2011, legislators reached a bipartisan agreement to raise the debt ceiling. However, in exchange for raising the debt ceiling, the agreement mandated that Congress put forward a plan to balance the budget—by December 31, 2012—or automatic spending cuts of 10% across the board would go into effect. These automatic cuts are also known as “sequestration.”
“Taxmageddon” is a term created by Congressional aides to refer to the date of December 31, 2012—when a large number of tax cuts are set to expire and tax increases from the Affordable Care Act are slated to take effect.
Those tax policies that are set to expire are the Bush-era tax cuts, the payroll tax holiday, the alternative minimum tax (AMT) patch, and the tax extenders.
- The Bush-era tax cuts, which President Obama extended, comprise of cuts that are applied to income, capital gains, and dividend taxes.
- As part of the compromise for extending the Bush-era tax cuts, President Obama successfully included the payroll tax holiday that would drop an individual’s withholding rate, allowing workers to keep more of their earnings.
- The AMT was put in place to make sure that those wealthy taxpayers who are able to lower their tax obligations through deductions, credits and exemptions—still pay at least the minimum amount of taxes. In 2010, Congress passed a two-year patch for the AMT. Some say that the taxes on the middle class will go up unless Congress extends the AMT.
- Tax extenders are designed to give temporary tax breaks to encourage development of specific industries—for example, R&D companies, investment companies, manufacturers, movie and television producers, and the oil, gas, and alternative fuel companies.
Check out this Congressional Research Service report for more information on the expiring tax provisions.
Starting January 1, 2013, five taxes from President Obama’s health care reform law will kick in. Those new taxes are the medical device manufacturing excise tax, a Medicare payroll tax increase, a surtax on investment income, itemized deductions for medical expenses, and the flexible spending account cap.
- The medical device manufacturing excise tax is a tax on the sale of certain medical devices by the manufacturer, producer or importer of the device at a rate of 2.3 percent. Class I medical devices are exempted from the tax, i.e., eyeglasses, contact lenses, hearing aids, and any device of a type that is generally purchased by the public at retail for individual use.
- High-income earners will also see their FICA Medicare payroll tax go up 0.9 percent—from 1.45 percent to 2.35 percent. The surtax on investment income affects the net investment income of most joint filers with adjusted gross income of more than $250,000 and $200,000 for single filers.
- The tax rates on long-term capital gains and dividends for these earners will jump from 15 percent to 18.8 percent.
- Itemized deductions for unreimbursed medical expenses will be raised from 7.5 percent of the adjusted gross income to 10 percent of the adjusted gross income—for most taxpayers.
- A $2,500 annual cap will be imposed on flexible spending accounts. These pre-tax accounts currently have no federal limit.
To learn more about each of these, please visit the Kaiser Family Foundation Health Reform Implementation Timeline.
“Sequestration” is a rarely used procedure in budget-related legislation that allows for automatic spending cuts to all federal discretionary and most mandatory federal spending programs.
The Budget Control Act authorized an increase in the debt ceiling in exchange for $2.4 trillion in deficit reduction over the next ten years. This total includes $1.2 trillion in spending cuts identified by the legislation, with an additional $1.2 trillion that was to be determined by a bipartisan group of Senators and Representatives known as the “Super Committee.” In the event the Super Committee failed to reach agreement, the bill created a trigger mechanism to implement burdensome, across-the-board spending reductions known as “sequestration.”
Under sequestration, federal agency budgets would be reduced annually by roughly $110 billion to meet the deficit reduction goals, with cuts split evenly between Defense and Non-Defense spending. Non-defense cuts includes a mandatory health spending cut of approximately $16.6 billion (i.e., Medicare and other mandatory programs) and discretionary health spending cuts of approximately $38.1 billion (i.e., National Institutes of Health, Centers for Disease Control and Prevention, Health Resources Services Administration). This was intended to be so unpalatable to Super Committee members that they would be forced to come together and make a deal.
As we all know, the Super Committee was not able to come to an agreement and the sequestration process was initiated. Without further Congressional action, these cuts will take effect on January 1, 2013.
Congress has not yet come up with a plan to balance the budget, so the fiscal cliff continues to loom. Neither party wants to see the U.S. go off the cliff, but serious negotiations will have to occur in order to stop this from occurring.
What do you think is going to happen? Do you think Congress will take us over the cliff? Or will they kick the can down the road and pass a temporary six month extension?
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