Get Ready To Fall Off A Cliff?

Iowa Farm Scene

The election is over. Congress and President Obama must now deal with big budget cuts and tax changes set to take place January 1.

Published on: November 12, 2012

The election is over and it's back to work for Congress and President Barack Obama. What's going to happen? The United States is about to fall off of a fiscal cliff. Huge mandatory cuts in federal spending will automatically kick-in and tax increases will take place if Congress doesn't do something before the end of 2012. Time is running out for lawmakers to deal with these pressing issues. If they can't agree on a fix before the cuts take effect January 1, the U.S. economy could retreat back into recession early next year, according to the Congressional Budget office.

What is the fiscal cliff and where did it come from? How will it affect you? Wallaces Farmer asked Neil Harl, emeritus professor of economics and ag policy at Iowa State University, to explain this situation and to share his views on what is likely to happen.

WHAT NEXT?: The looming fiscal cliff now facing Congress is job #1. Iowa State University emeritus professor Neil Harl, an expert on tax matters and ag policy, doesnt think Congress will accomplish a lot in its lame duck session, but hopefully the lawmakers will craft a compromise to avoid the massive jolt to the economy that falling off the cliff would cause.
WHAT NEXT?: The looming fiscal cliff now facing Congress is job #1. Iowa State University emeritus professor Neil Harl, an expert on tax matters and ag policy, doesn't think Congress will accomplish a lot in its lame duck session, but hopefully the lawmakers will craft a compromise to avoid the massive jolt to the economy that falling off the cliff would cause.

The fiscal cliff refers to the looming end of the Bush-era tax cuts and major across-the-board spending cuts to government programs—including the Pentagon, military spending, farm programs, lower Medicare payments to doctors, education, social welfare programs, etc. The tax increases and the spending cuts could total $600 billion in 2013.

Spending cuts and tax increases on all taxpayers are set to go into effect
In the summer of 2011 Republicans in the U.S. House of Representatives refused to raise the ceiling on the federal debt unless spending cuts were made in government programs. A bipartisan super-committee of both Democrats and Republicans was formed and given the task of finding $1.2 trillion in budget savings over the next 10 years. The committee was unsuccessful, they couldn't agree on where to make the massive reductions in spending. So automatic across the board spending cuts, a process called sequestration, were mandated to start taking place January 1, 2013—unless Congress and the President got together and agreed on an alternative plan before then.

"To provide a deadline and an incentive to get something done on solving the massive federal deficit, Congress and the Obama Administration agreed to put these automatic spending cuts in place beginning January 1, 2013," says Harl. "Also, a number of income tax breaks expired at the end of 2011 and more are scheduled to expire at the end of this year. In addition, Congress needs to decide what to do about the federal estate tax. It is scheduled to 'sunset' (go back to 2001 levels) at the end of 2012."

How steep will tax increases and reductions in federal spending be?
Thus, in January income taxes are set to go up when the Bush-era tax cuts expire; estate taxes are scheduled to increase; automatic spending reductions totaling $109 billion or more for 2013 are due to kick in for a number of programs; and Medicare payments would be slashed unless Congress acts. Another issue staring Congress in the face is the 2012 farm bill which has yet to be passed. Farm bills usually last for 4 or 5 years and the 2008 farm bill expired September 30, 2012.

ISU's Harl has studied tax policy and ag policy for many years. What does he think will happen with these issues in Congress in the coming weeks and months? He says it's a bit early to speculate, but here's how he sees things possibly shaping up.

Hopefully the new Congress that convenes in January will realize just how serious the situation is, says Harl. Also, the Congress that meets in this lame duck session between now and the end of 2012 will realize things aren't the way they hoped they would be. "For months the belief in some quarters was there would be a new occupant in the White House and there would be tax cuts and deep reductions in federal spending," Harl notes. "Now, after the November 6 election, that isn't likely to occur to the extent many people thought it would."

The fiscal cliff is a very serious matter Congress now faces
Thus, the results of the November 6 election are a game-changer in that respect. The question is will the present Congress and the new Congress that meets in January look at this problem with the seriousness that it deserves? The fiscal cliff does matter and Congress needs to consider how to remedy this situation very carefully."

"I don't expect Congress will accomplish too much in the lame duck session," says Harl. "What they may do is pass a farm bill—that's a good possibility. Regarding tax policy I think there will be discussion and debate. What may happen is we'll end up with a one-year extension of the current tax rules. Maybe not across the board on all tax rules, but perhaps a one year extension--to give the next Congress beginning in January an opportunity to look carefully at what is needed to close the federal deficit and assure economic growth."

That's the big issue now. "I think the fiscal cliff is really the biggest issue facing our nation, and it's going to come up for debate in this lame duck session," says Harl. "But the heavy lifting to really do something about solving the deficit problem will be done next year. Behind the scenes there will be an effort to craft a grand compromise. The question is, however, is there willingness to compromise between the leaders of the two parties in Congress?"

Need to be careful to not cause severe disruption to economy
Harl thinks the Simpson-Bowles plan (named for former U.S. Senator Alan Simpson from Wyoming and Erskine Bowles, a highly respected advisor to Presidents) provides a good template for solving the deficit problem. This plan represents a balanced approach in terms of cutting spending, Harl says, and it also includes some tax increases. "We're going to have to get more revenue in the system to help close the huge gap in the federal budget," he says. "We'll have to endure some cuts in spending on programs and Congress needs to stretch those over a time period that's long enough so the cuts don't upend the U.S. economy."

He adds, "We are seeing better numbers now in the U.S. economy—housing numbers are improved, the economic growth pattern is a little better than it was. I think we can see a better economy down the road. However, we want to be sure we don't cut that off with sharp cuts in federal spending and/or big increases in taxes without some effort to try to ease the pain. The adjustments need to be stretched over a long enough time period of time so they don't cause a serious disruption of the economy."

What will likely happen with income tax, which is set to increase?
In terms of what we are likely to see, Harl thinks we're going to see an increase in taxes. The big question is the cutoff. There is a lot of talk about tax increases for those people whose income is above $250,000 and that proposal is up for negotiation. He believes the cutoff may end up higher than that but it is one area where there might be a possibility for compromise. "There has to be some increase in revenue coming into the U.S. Treasury and we need cuts in federal spending as well," says Harl.

The current top tax rate on income is 35%. It was set as part of the Bush-era tax cuts and is due to expire at the end of this year and revert to a 39.6% rate. President Obama has proposed extending the tax cuts for married taxpayers with less than $250,000 in annual income or single filers with less than $200,000 in annual income, but not for taxpayers above that income level.

If no action is taken before the Bush-era tax cuts expire, the tax rate on dividend income will rise from 15% to the top individual tax rate (39.6%), and the tax rate on long-term capital gains will rise from 15% now to 20%. President Obama has proposed maintaining the 15% long-term capital gain rate for taxpayers with income less than $250,000. He has also proposed retaining the 15% dividend rate for taxpayers with income less than $250,000.

Taxpayers currently must pay the greater of regular income tax or the alternative minimum tax (AMT), which has a top tax rate of 28%. President Obama's proposed tax plan would permanently extend the AMT and indexes the AMT exemption for inflation. It also creates the "Buffet rule," which states that households earning more than $1 million per year would pay a minimum 30% income tax rate.

Individuals may claim certain itemized deductions and personal exemptions without limit. President Obama made two proposals during the 2012 presidential campaign: eliminate itemized deductions for housing, healthcare, retirement and childcare for individuals with more than $1 million in annual income, and limit the benefit of itemized deductions to 28% for taxpayers in higher rate brackets.

Federal estate tax also scheduled to change at end of 2012
What is likely to happen with the federal estate tax? Harl doesn't think we're going to see the current law sunset and go back to 2001. He expects there will probably be a one-year extension of what we have now—which is $5 million plus the inflation adjustment—which brings it to $5.12 million at present. "The one year extension would give Congress time to make a careful assessment of the federal estate tax and gift tax, and take a careful look at the income tax as well," says Harl.

The Obama Administration's position has been to have a $3.5 million exemption for the federal estate tax and a 45% tax rate. Harl expects going forward after a possible one-year extension, we will see at least that much of an exemption contained in the new tax law. "My guess is Congress will agree to $5 million with an inflation adjustment, which is what we have now, and that will be in effect either for 2013 or after a one year extension if they do enact that. It would also have a 35% tax rate and a new basis at death."

Portability, Medicare and Social Security are also issues
Are there any urgent tax issues that need to be dealt with soon, as opposed to later? There are several things, says Harl. "The portability issue should be reenacted. It's not part of the sunset and it needs to be reenacted so people who have been banking on it aren't put at a disadvantage. There are some other areas where tax changes that could go into effect could be quite tempting and I think those should be singled out and addressed, if not in the lame duck, then at least in the new 113th Congress that gets underway in January."

Harl believes Medicare and Social Security programs are not in jeopardy of being axed. There may be some changes in these two programs, but this is an area for compromise, he notes. "What Congress and the American people need to face is, no one is likely to walk away from the tax law changes and the cuts in spending and be pleased with every part of it," says Harl. "We've got to keep the best interest of the country in mind, and that means some people are going to have to pay more in taxes and some programs will suffer cuts in spending. This is necessary to get the federal budget back on an even keel."

It's going to be a very interesting Congress to watch in 2013
Some farm organizations are concerned about the alternative minimum tax. What are Harl's thoughts? "The AMT needs to get some attention fairly soon because I don't think Congress really wants to jolt taxpayers that much," he says. "It's a matter of getting the AMT passed as part of the tax extension in 2012, then taking a look long-term at where we're headed in terms of the alternative minimum tax being part of a broader tax package."

If widespread tax reform measures eventually make their way through Congress, then it may well be that the alternative minimum tax may not be so important and it might even disappear. "But I doubt it," says Harl. "I think we'll still probably have the AMT. The question is whether it will be at the same relative level as it has been in the past, adjusted for inflation."

True, the AMT is costly but a lot of other taxes are costly too, and there are priorities, he adds. "Tax policy is a tough call because different income groups suffer differentially when it comes to that type of change in the tax law."