December 2012

What Happens if we Fall Off the “Fiscal Cliff”?

By Amy K. Frantz

The “Fiscal Cliff” on which the country is standing at the precipice has been in the news for weeks now, and taxpayers all over America are waiting to see whether President Obama and members of Congress can pull us back from the edge or allow us to fall off. Which tax rates and deductions are involved in the fiscal cliff?  And what will be the impact on the U.S. and Iowa if the fiscal cliff is not resolved?

The major component of the fiscal cliff, so named by Federal Reserve Chairman Ben Bernanke in an appearance before Congress earlier this year,[1] is the expiration of the Bush-era tax cuts.  Personal income tax rates will revert to the previous rates, from the 10 percent tax bracket rising to 15 percent, up to the top rate increasing from 35 percent to 39.6 percent.  Additionally, the capital gains tax rate will rise, from 15 to 20 percent.  The Bush tax cuts also reduced the marriage penalty and increased the child tax credit, changes that will disappear if Congress and the President do not act.

Other components of the fiscal cliff include the expiration of the payroll tax cut that reduced the employee portion of the social security payroll tax by 2 percent. Additionally, Congress and the President have not yet approved the annual patch in the Alternative Minimum Tax (AMT) for the current tax year (2012), without which “the AMT exemption level would revert to what it was twelve years ago…[meaning] millions of middle-class taxpayers could see a substantial tax increase.”[2]

All of these factors, along with some tax increases included in ObamaCare that begin on January 1, 2013, combine for a total tax increase of nearly $500 billion[3] (yes, billion, with a B) next year!  Allowing our country to fall off the fiscal cliff will have a devastating impact on our nation’s economy:

The real and very dangerous effect of the fiscal cliff is what the tax rate increases would do to production over the long term. The tax hikes would slash the incentive to produce goods and services in the United States on a permanent basis (or at least until the lower tax rates were restored).  Very quickly, there would be job losses.  Within a few years, there would be less capital for workers to work with and thus lower productivity gains and commensurately lower wages and salaries.

The fiscal cliff would raise the cost of accumulating capital as higher taxes raise the rate of pre-tax earnings (the ‘service price’) needed to justify acquiring the plant, equipment, or buildings being considered by investors. The higher taxes would make it less rewarding to expand factories, mines, and farms, and to build additional residential or commercial property.  The tax increases would reduce the incentive to enter the work force or to work longer hours either as an employee or in running a business.  Lastly, higher taxes would reduce the incentive to save, as opposed to consuming one’s income.[4]

Our nation’s Gross Domestic Product (GDP) would suffer if the $500 billion tax increase is allowed to occur. Over the next ten years, higher taxes would “lower GDP by 9.61 percent below its projected long-run levels.”[5]  “We might expect the tax increases to reduce the growth rate of GDP and employment by between 1 and 1.5 percent a year for the first five years and a bit less than 1 percent for the next five years,” writes Stephen J. Entin of Tax Foundation.[6]

What is the impact on the typical Iowa taxpayer of the fiscal cliff? Nick Kasprak of Tax Foundation looked at Census and IRS data to determine the impact on a “median two-child family in each of the fifty states.”  Tax Foundation compared the federal tax bill for this typical family from tax year 2011 to what the tax bill will be in 2013 for this family if the “Bush-era and Obama tax cuts expire and AMT remains unpatched.”[7]

In Iowa, this typical family would face a federal tax increase of $3,383. It is easy to see why the tax increase of the fiscal cliff would have a destructive impact on the economy if Iowa families must divert more than $3,000 of their income from paying bills and other expenditures to sending those funds to the federal government to satisfy a larger federal income tax bill.  For most typical Iowa families, the increased tax burden will force them to make cuts in their family budget.

Falling over the fiscal cliff on January 1, 2013 by allowing the Bush tax cuts to expire as well as other tax increases will be damaging to our nation’s and Iowa’s economy. Our elected leaders cannot allow this to happen!

Amy K. Frantz is Research Vice-President at Public Interest Institute.

The views expressed herein are those of the author and not necessarily those of Public Interest Institute or Tax Education Foundation.  They are brought to you in the interest of a better-informed citizenry.

[1] Curtis S. Dubay, “Taxmageddon: Massive Tax Increase Coming in 2013,” The Heritage Foundation, April 4, 2012, <http://www.heritage.org/research/reports/2012/04/taxmageddon-massive-tax-increase-coming-in-2013> accessed November 21, 2012.

[2] Nick Kasprak, “How Would the Fiscal Cliff Affect Typical Families in Each State?,” Tax Foundation Fiscal Fact, November 12, 2012, <http://taxfoundation.org/article/how-would-fiscal-cliff-affect-typical-families-each-state> accessed November 28, 2012.

[3] Dubay.

[4] Stephen J. Entin, Senior Fellow, “Diving Off the Fiscal Cliff: An Economy on the Rocks,” Tax Foundation Special Report, pp. 1-2, November 27, 2012, <http://taxfoundation.org/article/diving-fiscal-cliff-economy-rocks> accessed November 28, 2012.

[5] Ibid, pp. 3-4.

[6] Ibid, p. 8.

[7] Kasprak.