In an unusual act, Congress convened and passed a big time piece of legislation on a major holiday – New Year’s Day.
The bill, the Taxpayer Relief Act of 2013, prevents the country from slipping off of the so-called fiscal cliff and it seems to have worked–at least temporarily. Instead of collapsing on the first trading day of the new year, the financial markets had a strong rally on news of the passage of even an imperfect bill.
What Just Happened with Congress and the Fiscal Cliff?
The fiscal cliff negotiations were originally expected to include tax issues, spending, deficit reduction and even a hint of real tax reform. Nothing that dramatic came about, but here are some highlights of what has been delivered:
- Most Bush-era tax cuts have been made permanent
- Jobless unemployed insurance benefits for 2 million long-term unemployed were extended for a full year
- A Medicare reimbursement cut of 27% has been prevented
- The top tax rate has been increased from 35% to 39.6% for individuals earning over $400,000 and couples earning over $450,000
- Taxes on high income taxpayers will also increase on income from capital gains and dividends as well as inherited estates
- Blocked a provision that would have made millions of middle class taxpayers subject to the Alternative Minimum Tax (AMT)
Details are still unfolding on just what the legislation includes, and many of the changes have been set aside for future debate.
The Payroll Tax Cut is the Biggest Casualty on the Tax Side
One of the most hotly contested issues in the months-long fiscal cliff fight has been whether or not to preserve the 2% payroll tax cut enacted under the Bush Administration.
This has been seen as an important stimulus to the economy, helping to increase job growth and restore stability to the housing market. The counter argument however, is that it has been a drain on Social Security funding, yet another of the nations hotbed issues.
Congress decided not to extend the payroll tax cut, and it will be one of the biggest negative effects of this legislation.
The loss of the 2% payroll tax cut means an average taxpayer earning $50,000 per year will pay an additional $1,000 in income taxes. This will result in a loss of spending power expected to remove $120 billion from the economy just in 2013 alone.
It should be noted though that this was one tax cut that both parties were expected to let expire as the payroll tax cut was always meant to be a short-term cut.
The Big Tax Changes that are Part of the Taxpayer Relief Act of 2013
For those in the 10% bracket you can be happy your rate is now permanent and will not go up to 15%.
On the other end, those individuals making over $400,000 and couples making over $450,000 will have their bracket jump from 35% to 39.6% (remember we have a progressive tax so not all income gets hit with new rate). This new rate was last seen in the 90′s.
Also affecting those individuals making over $400k and couple making over $450k, the tax rate on dividends and capital gains go from 15% to 20%.
Estate taxes for estates valued at over $5 million will have a rate of 40%, up from 35%.
There is also a provision to make the AMT, Alternative Minimum Tax, permanently tied to inflation. In prior years it had to be “patched” or else many would get sucked into a threshold that didn’t change.
There are new phaseouts on itemized deductions and personal exemptions for individuals making over $250,000 and couples making over $300,000. Like the highest tax rate these phaseouts were originally from the Clinton-era.
Now permanent, the Child and Dependent Care Tax Credit allows working families a credit of up to 35% of dependent child-care expenses up to $3,000 per child or $6,000 per family.
The Child Tax Credit (stays at $1,000 instead of the $500 it would have dropped to), Earned Income Tax Credit, and the American Opportunity Tax Credit are extended for five years, helping those with children.
What Might Have Happened Had a Deal Not Been Struck
There have been speculations worthy of the Y2K apocalypse before the passage of the legislation. They ranged from the collapse of financial markets, to radically higher unemployment, to dramatic increases in interest rates.
Thankfully, we’ll never have to find out if any of that would have happened, but it has been estimated that taxes would rise by $500 billion just in 2013 if Congress had not acted.
That could trigger a very uncomfortable recession at the very least.
Unfinished Business: Spending Cuts
There’s not much to say here – they didn’t happen.
Much of the debate centered around coming up with the proper mix of tax increases and spending cuts. But in the usual way that legislative bodies behave, the difficult decisions – the spending cuts – have been deferred at least until March.
We can guess that they’ll be extended well beyond then too.
The Deficit: Business as Usual
That brings us to yet another fiscal cliff no-show, the deficit.
Or better put, any action to reduce it.
Congress will be forced to deal with the deficit late in the first quarter of 2013 when the government’s debt ceiling will once again be reached. It will remain to be seen whether Congress will get serious about spending cuts, or simply rely on passing a higher debt ceiling to keep the status quo going for yet another year.
Wall Street’s Clout
It’s pretty obvious that Congress is intent on pleasing at least one part of its constituency: Wall Street.
A deal that could not be hammered out for months was curiously struck on New Year’s Day, just before the first trading day of the new year. In a rare show of unity, Congressional members from both parties came together in order to avoid the wrath of the financial markets that might have taken place in the event no deal was finalized.
Despite the fact that the Bush era tax cuts have largely been preserved, it appears that just about everyone’s taxes are going up. Though the emphasis is most heavily on those earning over $400,000, virtually everyone with an earned income of up to $113,700 will see their income taxes rise by a solid two percentage points.
There’s been much speculation that the elimination of the payroll tax cut will have a negative effect on employment. It is however possible that Congress’s action on the fiscal cliff will create enough sense of direction that the negative effects of the payroll tax cut will be offset.
We’ll have to wait and see on this one.
From all the published statistics out so far, it looks like the deficit is only going higher. How much effect this will have on interest rates, and how quickly that will play out, is anyone’s guess. We’ll have to see how Congress tackles spending in a couple of months.
In a real way, the legislation that passed looks like a solid strike in favor of business-as-usual. We can probably expect a continuation of very slow growth, at least until the full effects on the deficit and on interest rates can be more adequately measured.
There are those that have speculated that diving off the Fiscal Cliff, though painful in the short-term, would actually help the economy in the long-run. Still, having the tax rates set helps crate stability which employers and the market crave.
The financial markets
The market reaction so far has been positive, but that could be a relief rally more than anything else. Many cashed out capital gains at the end of 2012 in order to lock in the lower tax rate.
It’ll be at least a few weeks before we’ll get a better handle on this. Market reaction may ultimately be positive since the financial markets love stability.
And in a way, stability is exactly what this legislation preserves, even if it does little to move us forward. But if rising deficits cause interest rates to increase quickly, market reaction could very much be the opposite.