Those who pay attention to political, economic and financial issues are well aware of the frightening realities of the “fiscal cliff” — the expiration of the Bush-era tax cuts and significant spending cuts set to go into effect on Jan. 1.
As of Friday, things were not looking promising regarding any agreement among congressional leaders and President Barack Obama that would avert the consequences of going over the cliff. Unfortunately, we face other problems that threaten the economy, even if the fiscal cliff were to be successfully neutralized.
AMT
The alternative minimum tax, or AMT, was initially established in 1969 and was then updated in 1982 to its present form. In simple terms, it was enacted to prevent wealthy Americans from taking “too many” deductions, thereby lowering their tax burden.
No provision was made in the legislation for inflation, and as a result, Congress has routinely passed “patches” to prevent AMT from affecting middle-income individuals. This year, however, because members of Congress believed (incorrectly) that failing to pass a patch on AMT would give them more leverage in the fiscal cliff negotiations, no patch was passed. This means that roughly 28 million families would owe the IRS $86 billion in additional taxes, unless a patch is put into place retroactively.
Yes, we are talking about the 2012 tax year, not 2013! As bad as the fiscal cliff consequences could be, they would not begin until the 2013 tax year, giving Congress more time to pass legislation that is retroactive to the beginning of 2013. The more time that passes, the harder it will be to address the effects of AMT on the 2012 tax year.
As a result of Congress’ failure to act, the tens of millions of households exposed to the AMT would pay, on average, another $2,250 in taxes for 2012. On the whole, 98 percent of those with incomes between $200,000 and $500,000 would pay an additional $11,000 in AMT for 2012. About 88 percent of those with incomes of $100,000 to $200,000 would pay an additional $3,100, and the majority of Americans with earnings between $75,000 and $100,000 would have some AMT liability.
About 90 percent of the $86 billion of additional taxes due as a result of AMT would be paid by the top 20 percent of earners. These are the consumers who have discretionary income to go out and buy things that drive economy growth — they are the consumers who really count, if we want the economy to grow.
Payroll Tax Holiday
The payroll tax holiday will also expire in 2013, so families would potentially be grappling with the AMT while coping with less take-home pay. For the past two years, many of us have had a small tax break in our paychecks, since payroll taxes were cut by 2 percentage points. This amounted to more than $100 billion in additional take-home pay. Again, as with the AMT, no action was taken by Congress to extend this payroll tax holiday, so in essence, working Americans will see an immediate 2 percent increase in payroll taxes, starting Jan. 1.
Debt Ceiling
This past week, Treasury Secretary Timothy Geithner announced that as of Dec. 31 (that’s today), we would once again slam into the debt ceiling, which currently stands at $16.4 trillion.
In the summer of 2011, we ran up against the debt ceiling, requiring Congress to vote to increase it, or face government shutdown. Lawmakers couldn’t agree, and the result was that the government basically shut down. This resulted in Standard & Poor’s reducing the U.S. sovereign debt rating to AA+ from AAA on Aug. 6, 2011, sending shock waves around the world, and causing a serious sell-off in U.S. financial markets. Stocks lost 30 percent shortly thereafter.
In fact, the spending cuts set to go into effect on Jan. 1 as part of the fiscal cliff are a direct result of the negotiations surrounding the debt ceiling increase from 2011. Now we face either raising the debt ceiling to an even more unsustainable level, or, alternatively, government will once again shut down.
Geithner has some trickery he can use to finance government operations, probably into February, so there is some time remaining for Congress to act. But with the fiscal cliff dominating their attention, it will likely be much more difficult to get an agreement on the debt ceiling this time around.
With all of these challenges, one would think Congress and Obama would have worked a little harder to put legislation in place before time ran out. The new Congress takes over on Jan. 3, with the new members coming in from the November elections, and those who lost leaving. It is unlikely that we will get much, if any, action prior to the changeover.
While I believe we will eventually see some kind of agreement on the fiscal cliff and the debt ceiling, I have a hard time imagining any “solution” that will be effective at addressing the dual challenges of reducing the national debt and budget deficits, while at the same time fostering economic growth (or to put it more directly, avoiding another recession). Even if politicians on both sides of the aisle were 100 percent willing and motivated to find that magic solution to accomplish both of these goals, I just don’t think there is that magic solution.
What I do know is that we all face some very serious challenges, and we should all expect tough times ahead.
— Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at craig@craigdallen.com or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.