As an estimated one million Times Square revelers counted down the seconds to the New Year, one hundred U.S. senators counted down the votes to approval of a January 1 legislative compromise to prevent across-the-board tax rate increases and spending cuts that has come to be known as the “Fiscal Cliff.” The House of Representatives followed suit later in the day.

Like most New Years, this agreement brings good news and bad news. The good news is that democrats, led by Vice President Joe Biden, and republicans, led by Senate Minority Leader Mitch McConnell (R-KY), hammered out compromises to prevent everyone’s income tax rates from going up on January 1. Economists had predicted that the combination of higher income tax rates and a scheduled “sequester” of a big chunk of defense and domestic spending could have triggered a recession in 2013. Read more.

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Fiscal Cliff Deal: Happy New Year?

Wed Jan 2, 2013

As an estimated one million Times Square revelers counted down the seconds to the New Year, one hundred U.S. senators counted down the votes to approval of a January 1 legislative compromise to prevent across-the-board tax rate increases and spending cuts that has come to be known as the “Fiscal Cliff.” The House of Representatives followed suit later in the day.

Like most New Years, this agreement brings good news and bad news. The good news is that democrats, led by Vice President Joe Biden, and republicans, led by Senate Minority Leader Mitch McConnell (R-KY), hammered out compromises to prevent everyone’s income tax rates from going up on January 1. Economists had predicted that the combination of higher income tax rates and a scheduled “sequester” of a big chunk of defense and domestic spending could have triggered a recession in 2013. 

The bad news is that this is a fiscal cliff avoidance deal only; it includes almost nothing to slow the growth of federal government spending. Indeed, the New Year’s Day agreement does little to reduce present or future federal budget deficits. Government spending will continue to march upward and the U.S. public debt will continue to grow from the present $16.4 trillion to over $20 trillion in ten years.

A “Thelma and Louise”-style cliff dive was avoided but only because Congressional democrats and republicans postponed tough decisions about reducing annual $1 trillion federal budget deficits and punted on our skyrocketing public debt.

Let’s look at some of the preliminary details:

First, Congress and the President agreed to permanently extend Bush-era income tax rates for 99% of taxpayers. Except for high-income households no one will see an increase in income tax rates for 2013 and beyond.

President Obama and Congressional democrats made a big concession to republicans in agreeing to increase the income threshold at which the highest marginal tax rate will kick in.  The president had wanted to increase the top rate from the present 35% to the Clinton-era top rate of 39.6%, and to apply it to individuals earning more than $200,000 and couples earning more than $250,000. The final package establishes a new maximum rate of 39.6% but it applies only to individuals with taxable incomes above $400,000 and to couples earning more than $450,000.

Republicans also made a big concession: they voted to increase marginal tax rates, the first time that’s happened in at least 20 years. They also accepted caps on itemized deductions and a phase-out of the personal exemption for individuals making more than $250,000 and couples making more than $300,000.

The second big piece of Washington DC’s New Year’s Day accord is that the president and Congressional leaders decided to kill the 2% Social Security payroll tax holiday in effect for 2011 and 2012. As this blog predicted months ago, democrats and republicans concluded that siphoning off over $100 billion every year that had been earmarked for the Social Security Trust Fund was not prudent given the precarious state of Social Security’s finances.

To be sure, workers who had been receiving an average payroll tax break of $1,000 for the past two years will notice right away that their checks are lighter by some $20 a week.  Put another way, while our income tax rates will stay the same our payroll tax rate will go up compared to 2011 and 2012.

The fiscal cliff agreement contains a number of other important provisions, including a permanent fix in the Alternative Minimum Tax (AMT) which will prevent the AMT from snaring some 30 million new taxpayers for the first time when they file their 2012 tax returns, according to the Washington Post.

In addition, the agreement extends several expiring tax provisions, including the R&D tax credit and certain other education-related credits. And at a cost of some $30 billion emergency unemployment insurance benefits will be extended for another year. Meanwhile, the package includes the so-called “doc-fix,” a postponement for another year of scheduled cuts in Medicare reimbursements to physicians.

The obvious shortcoming in the package is that it contributes little to deficit reduction—only about $600 billion over the next decade, or about $60 billion per year. With annual federal budget deficits in the trillion-dollar range as far as the eye can see, a $60 billion contribution, while helpful, is but a drop in the deficit bucket.

Unlike most last-minute Capitol Hill cliffhangers, the New Year’s Day package is more ceasefire than compromise. There will be few handshakes and little celebrating. President Obama got what he wanted: an increase in tax rates on high-income taxpayers.

But the absence of any provision to restrain government spending, indeed to apply new revenue from the tax rate increase to deficit reduction instead of to pay for more government benefits in the form of unemployment insurance or tax credits, portends a resumption of partisan political warfare in the New Year.

Washington DC has avoided going over the fiscal cliff. Higher taxes on the rich will become law. But more cliffs lie ahead, including a vote to increase the public debt ceiling sometime in March. Meanwhile the national debt grows and grows toward 100% of our GDP.

One can only hope that the 113th Congress that will convene on January 3 with 12 new senators and 67 new House members will make the difficult decisions needed to reduce annual federal budget deficits and put our mammoth public debt on a sustainable trajectory. A 3-D iceberg of deficits, debt and demographics looms on the horizon. Perhaps this time Titanic can avoid it.