Friday, January 4, 2013

Stopping Short of the Cliff — For Now…

After what seemed to be 7 week staring contest since the Presidential election, the Senate and White House were able to hammer out a last-minute 2am compromise to stave off going over the Fiscal Cliff—and with the House eventually voting to approve the plan on January 1, the debate surrounding the country’s fiscal crisis is essentially postponed.

And so we are left with the American Taxpayer Relief Act of 2012. In this commentary we will briefly outline the essential details of the plan as a primer for your potential tax impact for 2013, and touch on the fight yet to come later in early spring.

The Details 

According to Congressional sources, here are a few of the major provisions of the deal:
  • Current tax rates will remain in effect for earned income below $400,000 for individuals and below $450,000 for couples. However, income tax rates will permanently increase from 35% to 39.6% for incomes above these thresholds.
  • For earners in the top bracket, capital gains and dividend tax rates would return to 20% from 15%. (This was far more favorable for investors than the outcome that would have occurred without an agreement, whereby dividend income would have been treated as arned income and taxed at a top rate of 39.6%.)
     
  • Postpones for two months the start of $1.2 trillion in automatic spending cuts known as sequestration.
     
  • Raises $600 billion in revenue over 10 years through tax increases on wealthy Americans. • The alternative minimum tax was permanently indexed for inflation. (The lack of inflation indexing had resulted in more and more individuals falling under the requirements of the alternative minimum tax and required annual legislative patches to fix.)
     
  • Provisions were reinstated that phase out personal exemptions and deductions for single filers making more than $250,000 and couples making more than $300,000.
     
  • The estate tax rate was increased from 35% to 40% on estates of over $5 million.
     
  • Tax credits included in the 2009 stimulus were extended for five years, including a child tax credit and a refundable credit for college tuition.
     
  • The payroll tax, which had been temporarily lowered for the past two years, increased back to 6.2% from 4.2% for all workers' first $113,700 of income. As a result, a family earning $50,000 a year will see a reduction of after-tax income of $1,000. (This is not a tax increase, merely a return to normalcy. The tax is how the large entitlement programs of Social Security & Medicare are funded.)
     
  • Other elements of the legislation extended long-term unemployment insurance for one year and prevented a 27 percent reduction in payments to Medicare providers for one year.
     
What’s Next

Almost as important as what was included in the bill is what was left out. Foremost among these issues is the debt ceiling, which was not increased as part of the legislation. The U.S. unofficially hit its debt ceiling on December 31 and the U.S. Department of Treasury is undertaking "extraordinary measures" in order to meet the country's obligations. It is currently estimated that the Treasury will not be able to pay all of its bills by late February or early March unless Congress acts to increase the debt limit.

The deal does nothing to reform entitlements or comprehensively address simplifying our tax code, and looks likely to increase political rancor in the near future.

The highly divisive deficit reduction, spending cut and entitlement reform issues are now expected to become part of the negotiations over raising the debt ceiling, which creates high risk of another congressional standoff and more investment market volatility in the first quarter of 2013. More specifically, we can expect debate over the following issues:
  • Automatic spending cuts, half in defense and half in domestic programs, which will be delayed for two months and then kick back in March 1 unless Congress can identify other offsets to avoid the sequestration.
  • A second sequester deadline looming in late March to cover the overspending since the first sequester.
     
  • The government's spending authority, which expires on March 31 without an increase in the debt ceiling. 
And let's not ignore the fact that by voting for the bill, 85 out of 236 House Republicans essentially acquiesced to the largest tax increase since 1990, ensuring more divisions within the splintered House Republican caucus. This means political confrontation is likely to continue to dominate headlines for several more months.

Crisis was averted in the short term, but many important and divisive issues remain unresolved. As developments unfold in Washington, we will continue to update you on the effects of our political leadership's decisions on your finances.