The Fiscal Cliff: What Is It? How Does It Affect Me?

Now that the election is done, there has been a bunch of talk about how to fix the “fiscal cliff.” But few people actually know what the fiscal cliff is or how it would affect them.

Fiscal Cliff Key Players

President Obama has planned a meeting with congressional leaders for next week. Commentators are talking about the disastrous effects of the fiscal cliff if we should go over it. But what does it really mean? How does it really affect you and your life? Here’s a short primer on the fiscal cliff.

Overview of the fiscal cliff

When people talk about the fiscal cliff, they’re mainly referring to several tax increases that are set to take effect in 2013, and a number of tax cuts that are set to expire at the same time. Here’s a short list of the main ones:

  • The Bush tax cuts expire – $156 billion)
  • The payroll tax holiday expires – $125 billion
  • Failure to patch the Alternative Minimum Tax (AMT) – $88 billion
  • Expiration of business expensing – $48 billion
  • Expiration of other tax extenders – $40 billion
  • New Obamacare taxes – $36 billion
  • Expiration of 2009 stimulus – $11 billion
  • Estate tax increase – $10 billion

These are annual amounts. So, over 10 years, this is a $5.1 trillion tax increase.

So, what does this mean for you, personally? Well, here’s a few specifics about the income tax increases:

  • The bottom tax bracket goes away (and starts getting taxed at 15%. So, if you make under $17,900 (as a married couple), then your taxes will go up by 5%.
  • The second tax bracket remains the same, so if you make between $17,900 and $60,550, your taxes will remain the same (except for the first $17K of income).
  • The 25% tax bracket goes up to 28% (incomes between $60,550 and $146,400, married)
  • The 28% tax bracket goes up to 31% (incomes between $146,400 and $223,050, married)
  • The 33% tax bracket goes up to 36% (incomes between $223,050 and $398,350, married)
  • And new tax bracket is created (39.6%) for incomes above $398,350

Here are some dollar amounts for you: if you’re married, in the middle class, you’ll pay between $895 more and $4,666 more in taxes next year. If you’re married and making $250,000/year, you’ll pay an additional $7,774 in income taxes in 2013 (with a total tax bill of $66,084.

Furthermore, the payroll tax holiday is also set to expire, going back to 6.2% from 4.2%. That means that if you make the median 2012 U.S. income in 2013, you will pay an additional $1,001 in payroll taxes. These are real numbers!

Economics

If the fiscal cliff hits us (and there’s a good possibility that many of the taxes will, including payroll taxes and Obamacare taxes), the economy will slow down. How much the economy slows down depends on which taxes are allowed to increase, and which ones are not.

For example, the Congressional Budget Office (CBO), which released a report on Thursday, says that if all the taxes planned for 2013 are implemented, it would slow GDP growth by 2%. Compare that to our current economic growth of ~1.5%, and you can see that we’re in negative growth, which means recession.

According to a New York Times article, a different analysis by Moody’s Analytics predicts that the fiscal cliff would create an economic slowdown of 3.6%, even higher than the CBO predicted.

However, if only the income tax increases on the highest tax brackets are implemented, says the CBO, the economy would only slow down by 0.25%, which is more palatable to economists, but still 16.7% of our total economic growth for the year! (Take note, those of you who re-elected President Obama because you thought it wouldn’t hurt the economy to tax the rich!).

The good news for the country, though, is that if the fiscal cliff actually happens, it will bring more revenue to the national treasury, and the government won’t have the high deficits that it’s had in the past few years. The deficits will only be about half what they were last year.

Politics

Now, for all of you who are now saying, “Oh, my goodness, I’m going to pay thousands of dollars more in taxes next year,” take heart. Both Republicans and Democrats want to save you. President Obama doesn’t want to raise taxes on the lower and middle classes. He only wants to raise taxes on the top income earners.

However, both parties want to find a way to end the payroll tax holiday, because it’s really hurting Social Security to not have that money going into the fund. So, you’ll likely see that tax go back to what it was. For those outside of Illinois, it will hurt only a little bit. However, for those in Illinois, who saw the payroll tax holiday offset by a 2% increase in the Illinois state income tax, you’ll actually get hurt again by the expiring payroll tax cut. For those in Illinos, it’s just a plain old tax increase, not a return to the old rates. The problem is, do you blame Governor Quinn now, two years after he implemented the income tax increase? Or do you blame President Obama for the “new” tax?

Many of the tax increases listed above will be used as bargaining chips by both sides, and some will end up coming back. The Obama tax increases are likely to be implemented, because they’re part of the president’s plan, and Republican lawmakers want people to feel the impact of the Obamacare law.

If I had to guess, I would say that the “compromise” that the two parties achieve in regards to the fiscal cliff will look much like this: Obama will allow all the Bush tax rates to continue, including the rates for the top brackets. In exchange, he will get the Republicans to concede to a return of the payroll taxes to their 2009 levels, and then will try to blame those new taxes on the Republicans once they hit. Republicans and Democrats will come together to fix the Alternative Minimum Tax law, putting another patch on it for a couple of years. The Obamacare taxes will be implemented. And, after it’s all done, President Obama will call for a new stimulus spending package to help the economy, which is still in the doldrums.

Fiscal Sanity Elusive

In short, politicians will come up with a short-term fix to the tax code, and each go their separate ways, blaming the other for the bad state of the economy. Instead of dealing with the long term problems of our deficit and debt, they will continue to be short-sighted panderers. Instead of fixing Social Security, Medicare and Medicaid, they will punt the costs into the next generation.

While you wait for Congress and the President to do their jobs, consider checking out the Fiscal Cliff Tax Calculator by clicking here, and find out how much more in taxes you’ll pay if they don’t act.

Discussion Question: How well do you think Congress and the President will deal with the fiscal cliff?