Falling Off the Cliff

The “fiscal cliff” coming at the end of this year (assuming Congress and the President fail to take action) involves substantial across-the-board budget cuts and the elimination of tax breaks, some of which have been in place for many years. The budget cuts (sequester) were the topic of a previous column; this time, I want to hit the highlights of the tax portion of the cliff.

A recent analysis by the Tax Policy Center of the Urban Institute and Brookings Institution indicates that the tax increase will amount to some $500 billion in 2013, about 20% higher than receipts would be otherwise. This translates into an average of almost $3,500 per household. The study estimates that 90% of households would see taxes rise, with the two biggest increases being the end of the temporary cut in Social Security taxes and the expiration of tax cuts implemented in the 2001-2003 timeframe (often referred to as the “Bush tax cuts”).

Average tax rates would rise for all income groups in the Tax Policy Center study, while after-tax income is reduced. For the lowest quintile of households, the average incremental tax was estimated to be $412, while the second quintile jumps up $1,231. For the middle quintile, the average federal tax change would be $1,984, with a $3,540 increase for the fourth quintile. The top quintile would see a change of $14,173 in the average federal tax bill. For those fortunate enough to be in the top 1% or top 0.1%, the increase is massive (at an estimated $120,537 and $633,946, respectively).

Marginal tax rates would also rise by an estimated five percentage points on wages and salaries, five percentage points on interest income, seven percentage points on long-term capital gains, and more than 20 percentage points on certain dividends. (Note that this is percentage points, not percent. For example, a rise from 10% to 15% is a change of five percentage points.) Such jumps are enough to change behavior, discouraging some workers and investors from the productive activity the economy so desperately needs.

As these additional tax dollars are pulled out of family and corporate budgets, less money is left for spending and saving. As with any stimulus to the economy (whether positive or negative), multiplier or ripple effects through the economy will serve to magnify the fallout. While in theory the tax receipts will also be injected back into the economy, government spending is certainly not viewed as an optimal economic growth strategy and increases in federal spending are neither a likely nor a desirable outcome.

Even beyond the quantifiable effects of looming changes in the tax structure is the effect on future economic development through reducing incentives to work, start a business, save, invest, and otherwise contribute to overall prosperity. While no one would argue that taxes are entirely avoidable, it is certainly true that the more responsible and equitable the tax system, the better the business climate. Eliminating tax cuts should only be undertaken after careful analysis of the likely fallout, not as a result of an arbitrary deadline and previous budget stalemate. Moreover, sudden changes can have much more disruptive effects than a long-term strategic effort to both enhance revenue and reduce outlays.

The ultimate path to responsible fiscal policy will doubtless involve a combination of mechanisms for generating revenues as well as spending cuts. The ideal tax system would be broad based, involve low rates, and be as equitable as possible. At the same time, the spending cuts would be achieved with the least damage to quality of life and the economy (which is certainly not the case with the sequester, the other major aspect of the fiscal cliff).

Some of the expiring tax cuts were never meant to stay in place for the long haul. They were viewed as temporary measures to get the economy moving. However, others have been in place for more than 10 years and their loss would lead to sizable ripples through the economy. Add to these tax increases the levies required to fund the Affordable Care Act, and the changes become significant enough to be felt in the monthly budgets of millions of families.

Providing national defense, quality schools, infrastructure, public health and safety, and other essential government functions involves substantial costs that must be recouped in large measure through tax levies on citizens and businesses. The issue thus becomes how best to allocate the tax burden such that it is as fair as it can be while minimizing the consequences for business activity and decision-making. If taxes result in consumer retrenchment and a significant disincentive for businesses to invest, expand, and create jobs, we all lose.