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The fiscal cliff deal still means US taxes are going to rise

Happy New Year!

Last night I was on BBC World News and BBC Radio talking about the fiscal cliff. I stressed the fact that the deal being worked out in Washington will still see a hefty rise in taxes for the middle class via the payroll tax and for wealthy Americans via a lapse of the Bush tax cuts. Moreover, under the deal approved by the US Senate, the automatic spending cuts have simply been delayed two months and the US is still over the debt ceiling. The House of Representatives still has not approved the deal – and there is some resistance to it.

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First, let me quote extensively from the Dallas Fed as to exactly what items are at issue because they give a good synopsis. I put this in the links the other day, so you may have read it.

The first and among the largest of these are income tax provisions contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 and companion legislation passed in 2003. Better known as the “Bush tax cuts,” the legislation included lower marginal rates on income, capital gains and dividends; a smaller “marriage penalty”; larger child tax credits; and gradual elimination of the estate tax. Extending these tax provisions would cost the government $110 billion in fiscal year 2013.

The second category concerns a design flaw in the alternative minimum tax (AMT)—a tax intended to ensure payments by high-income earners—that has increasingly ensnared middle-income earners. The AMT’s brackets are not indexed to inflation, causing an ever-deeper dip into the ranks of the middle class. For budgetary reasons, lawmakers adopted a series of patches rather than a permanent fix for this glitch. Another patch would cost $90 billion in fiscal 2013.

AMTJust how many Americans are shielded by these patches? Roughly 4 million taxpayers were subject to the AMT in tax year 2011 (Chart 1). Without a new patch, that number would immediately rise to 30 million and would escalate, possibly reaching 66 million over the next decade.

Not included in the AMT figure is an interactive effect with the 2001/03 Bush tax cuts. Because the AMT acts as a floor on how much income tax households pay, reductions in ordinary income tax rates increase AMT coverage, inadvertently broadening the AMT’s reach. This effect makes patching the AMT a more expensive proposition when accompanied by extension of the Bush tax cuts. The cost—$35 billion in fiscal 2013—also increases over time.

The third category, labor-market support, encompasses unemployment insurance extensions and a payroll tax cut of 2 percentage points that were enacted as part of the Job Creation Act of 2010. Studies suggest these measures have significant stimulative macroeconomic effects over the short term. However, some analysts believe further unemployment extensions may discourage job-seeking, while the payroll tax cut may have troubling implications for the solvency of entitlement programs such as Social Security over the longer term. Extending the labor-market support package would cost $115 billion in fiscal 2013.

The fourth category includes tax increases adopted under the Affordable Care Act of 2010. Principal among them is a 0.9 percent Medicare payroll-tax increase for upper-income workers and an accompanying 3.8 percent “payroll tax” applied to the investment income of high-income households. Also included are new taxes on specific manufacturers, such as medical device makers. Postponing these taxes would cost $25 billion in fiscal 2013.

The fifth category includes currently scheduled reductions in Medicare payments to doctors, hospitals and other health care providers. In the late 1990s, Congress examined Medicare reimbursements and concluded that a slower, sustainable growth rate in payouts to doctors and hospitals was needed to help safeguard Medicare’s long-run solvency. As soon as those limits began to bite, providers persuaded policymakers in 1997 to temporarily waive them, a reprieve that has continued through this year even as the gap between sustainable spending and actual reimbursements swelled to almost 30 percent. Continuing those waivers—the so-called “docfix”—would cost an estimated $10 billion in fiscal 2013.

Dallas Fed Fiscal Cliff itemsThe last component, across-the-board spending cuts, became a factor only last year. As part of the debt-limit agreement that narrowly averted a U.S. debt default in August 2011, lawmakers vowed to reach consensus on a $1.2 trillion “down payment” on deficit reduction over the next 10 years or submit to a “sequester,” automatic spending cuts that would fall equally on defense and nondefense portions of the budget beginning in 2013. Canceling the sequester would raise the deficit by $65 billion in fiscal 2013.

With these components and an “other” category that encompasses smaller provisions and feedback effects, fiscal cliff consolidation amounts to $560 billion in fiscal 2013 alone (Chart 2).

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The Bush tax cuts have been taken off the table below income for families over $450,000 and for individuals over $400,000. I believe the AMT provisions have been taken care of as well though I am not sure. The payroll tax cut is gone. I haven’t heard anything about the Affordable Care Act tax increases and the reductions of payments to healthcare providers. The ‘sequester’ automatic spending cuts have simply been delayed for two months This means that at best the fiscal cliff has become a clifflet. There will be an economic drag of perhaps 2% of GDP. In addition, we still have the potential for a voluntary default on US debt because of the debt ceiling. And more fiscal drag could come if the automatic spending cuts are not dealt with in the next two months.

Isn’t this what we should have expected? As early as August, we carried a post by Sober Look which warned that Obamacare tax increases and the payroll taxes, baskets one and two of the fiscal cliff items, would likely phase in. That is what has happened. AND we got tax increases on income over $250,000 on top of that. That’s where the 2% drag comes.

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Therefore, in October I wrote that “we should expect at least a Fiscal Clifflet for the US” and I saw this as putting the US and global economy in jeopardy of recession.

If you read the reporting of the fiscal cliff as I have you will see that no one gets it right except Bloomberg.

The budget deal passed by the Senate probably would crimp the U.S. economic recovery without stopping it.

The elimination of a 2 percent payroll tax cut, coupled with higher income taxes on the wealthy, will help reduce growth in the first quarter to 1 percent, from 3.1 percent in 2012’s third quarter, the latest data available, according to economists at JPMorgan Chase & Co. (JPM) and Bank of America Corp. The expansion will strengthen later in the year as the housing market continues to rebound, they forecast.

“It’s going to definitely present a headwind for the economy,” Michael Feroli, chief U.S. economist for JPMorgan Chase in New York, said of the fiscal pact that the Senate approved early today, sending it to the House of Representatives. “We’re looking for a downdraft in growth in the first half of the year, with the economy coming back in the second.”

The first half slowdown will mean that the U.S. will make limited progress in reducing unemployment in 2013, according to projections by Ethan Harris, co-head of global economic research for Bank of America in New York. He sees the jobless rate falling to 7.5 percent in the fourth quarter of 2013 from 7.7 percent in November 2012.

Everyone else is acting like we averted the fiscal cliff. We have not. In fact, the US has gone over the fiscal cliff because no deal was struck by the 1 January 2013 deadline. Moreover, the deal that could be struck will still see a fiscal drag on the US. Welcome to the new age of austerity in America. The only question now is whether austerity in America means recession or just slower growth. Only time will tell.

UPDATE: See here from Suzy Khimm for exactly what’s in the deal:

— Tax rates will permanently rise to Clinton-era levels for families with income above $450,000 and individuals above $400,000. All income below the threshold will permanently be taxed at Bush-era rates.

— The tax on capital gains and dividendswill be permanently set at 20 percent for those with income above the $450,000/$400,000 threshold. It will remain at 15 percent for everyone else. (Clinton-era rates were 20 percent for capital gains and taxed dividends as ordinary income, with a top rate of 39.6 percent.)

— The estate tax will be set at 40 percent for those at the $450,000/$400,000 threshold, with a $5 million exemption. That threshold will be indexed to inflation, as a concession to Republicans and some Democrats in rural areas like Sen. Max Baucus (D-Mt.).

— The sequester will be delayed for two months. Half of the delay will be offset by discretionary cuts, split between defense and non-defense. The other half will be offset by revenue raised by the voluntary transfer of traditional IRAs to Roth IRAs, which would tax retirement savings when they’re moved over.

— The pay freeze on members of Congress and all other federal civilian employees, which Obama had lifted earlier this year, will be re-imposed, .

— The 2009 expansion of tax breaks for low-income Americans: the Earned Income Tax Credit, the Child Tax Credit, and the American Opportunity Tax Credit will be extended for five years. 

— The Alternative Minimum Tax will be permanently patched to avoid raising taxes on the middle-class.

— The deal will not address the debt-ceiling, and the payroll tax holiday will be allowed to expire.

— Two limits on tax exemptions and deductions for higher-income Americans will be reimposed: Personal Exemption Phaseout (PEP) will be set at $250,000 and the itemized deduction limitation (Pease) kicks in at $300,000. 

—The full package of temporary business tax breaks — benefiting everything from R&D and wind energy to race-car track owners — will be extended for another year. 

— Scheduled cuts to doctors under Medicare would be avoided for a year through spending cuts that haven’t been specified.

— Federal unemployment insurance will be extended for another year, benefiting those unemployed for longer than 26 weeks. This $30 billion provision won’t be offset. 

— A nine-month farm bill fix will be attached to the deal, Sen. Debbie Stabenow toldreporters, averting the newly dubbed milk cliff

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About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.