The Possible Implications Of The Fiscal Cliff

The term fiscal cliff is said to have been coined by Ben Bernanke during hearings of the House Financial Services Committee in February 2012. On January 1, 2013 several major budget items are scheduled to expire. Among them are many tax incentives that have benefitted tax payers such as the earned income credit, child credits, and some subsidies for businesses, health care and education.

The end of 2012 will bring about the expiration of the Bush tax cuts, which are cuts that lowered income and investment tax rates that have been in effect since 2001. Also, as the year draws to a close, we will see the expiration of an extension of both the stimulus payroll tax cut, and emergency unemployment benefits.

These events are likely to create ripples throughout the economy by themselves; however, at the same time, we could experience the effects of additional cuts such as the “sequester” cuts, which were part of a negotiated debt-ceiling compromise in defense and health spending. January 1, 2013 will bring the 3.8 % Medicare Tax, instituted by the Affordable Care Act, which will be imposed on families who make $250,000 or more, or whose investment income exceeds the threshold.

If all of these provisions are allowed to hit around the same time, analysts agree that the impact on the economy will be substantial. The Congressional Budget Office estimates that if Congress cannot agree on a way to derail some of these deadlines, the economy could shrink by 1.3%. Thus, if the fiscal cliff issue is not addressed, large spending cuts and tax increases will be too burdensome for the economy to handle at one time. This could push the economy into recession, and would be the perfect storm of sorts.

The Election

Regardless of which candidate wins the election, he will certainly have his work cut out for him. The President and Congress must work together to find a way to address the expiring tax cuts, other tax cuts, and revenue generating ideas and strategies designed to curb the growing deficit. The following are some of the issues that need to be addressed and the candidates’ positions              on them:

  • President Obama has promised to extend the Bush tax cuts across the board, but let them expire on the “wealthy,” defined as those who make $250,000 or more per year.
  • Mitt Romney wants to extend the Bush tax cuts for one year and, thereafter, cut taxes across the board by 20%.

According to WealthManagement.com’s recent article entitled “On the Chopping Block”, there are a number of tax changes to watch as the year comes to an end, and it is important to understand the candidates’ perspective on these tax implications.

1. The payroll tax holiday.

It is expected that the payroll tax of 6.1% on Social Security (replacing the current 2% reprieve that workers have enjoyed over the last two years thanks to the Tax Act of 2010) will return. The purpose of this tax holiday was to put more cash in average workers’ pockets, so that someone earning approximately $50,000 per year would have saved about $20 a week.

2. Limiting versus capping certain deductions.

Over the past few years, many lawmakers have called for a limit on certain deductions for taxpayers who itemize, such as limits on deductions for mortgage interest, charitable gifts, and state taxes.

President Obama has proposed limiting to 28% the amount of interest a taxpayer may deduct on these items. Lobby groups representing these interests have been vigorously fighting against these possible changes. Recently, Romney has addressed these deductions and has proposed to enact a dollar cap, somewhere between $17,000 and $50,000, within which the deductions would be allowed. Anything beyond that cap would not be deductible.

3. Adjust tax status on municipal bond interest and life insurance build-up.

President Obama has proposed to limit the tax-exempt status of municipal bond interest to 28%. There has been push back by the $3.7 trillion municipal bond industry, and analysts believe that it is not likely that their taxability will change unless a similarly advantageous bond instrument replaces it, like a tax credit bond similar to the Build America Bonds created by the Stimulus Bill.

Romney has mentioned in his tax reduction and deficit reduction plans that the taxation of life insurance build-up may help to also generate revenue to curb the deficit.

The insurance industry is fighting this idea. The industry argued that insurance products and the tax benefits they provide help fund Americans’ retirements, and Americans have come to rely on the tax-deferred status of their insurance products. The total savings between municipal bond interest and life insurance build up, according to the Tax Policy center, is estimated to be about $70 billion a year.

4. Estate planning strategies.

If the President, newly elected or second term, does nothing to prolong or change these rates, on Jan. 1, 2013 the tax rates will revert to 2001 levels—55% and a $1 million estate, gift and GST tax exemption.

President Obama has stated that he would increase the estate tax rate to 45% and reduce the exemption to $3.5 million (or $7 million per married couple). He has also favored making portability permanent. Romney has proposed elimination of the estate tax entirely.

Hopefully after the election the big picture will become clearer, and Congress and the President will begin to address the issues leading us to the fiscal cliff.

About the author

Tom Orecchio, CFA, CFP®

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