Republicans and Democrats are wrestling with a variety of riddles that have come to be known as the fiscal cliff, a double whammy of tax increases and spending cuts scheduled for the start of the new year. Here is a primer on unraveling the knotty political and economic threads.
What exactly is the fiscal cliff?
The term refers to a combination of forced cuts and tax increases worth more than $500 billion. The best-known parts are the expiration of the Bush-era tax cuts and the automatic across-the-board cuts to federal spending.
If that’s all that is involved, what does all the talk of deficits, debt ceilings and other taxes have to do with the cliff?
The roots of the current deadline are in the Budget Control Act of 2011, a product of the political gridlock that formed much of the backdrop to President Obama’s first term. Congress had to increase the debt limit so that that the government could continue to borrow money, but conservatives balked unless the increase was coupled with spending cuts. When the dust cleared, caps were placed on some spending, the debt limit had been increased by $2.1 trillion and a so-called supercommittee of Congress had been charged to find spending cuts worth $1.2 trillion over 10 years.
Was $1.2 trillion in spending cuts found?
No. Thus what was designed as a corset to force lawmakers to cut spending fat became instead a straitjacket. Because the supercommittee couldn’t reach agreement, automatic spending cuts will be triggered beginning Jan. 2 – a practice known in congressional parlance as sequestration. Most analysts agree that defense would take about a 9.4% hit. Civilian spending would lose about 8.2%, including a 2% cut to Medicare providers and additional cuts to programs such as Head Start.
That’s the spending portion of the cliff; what about taxes?
The part of the tax package that has gotten the most publicity has been the Bush-era tax cuts. Tax cuts were approved in 2001 and 2003 that brought down tax rates for everybody, and those cuts expire Dec. 31 unless Washington acts. The White House estimates that a middle-class family of four would pay another $2,200 a year.
Is it just the income tax rate that’s at stake?
No. Several tax policies are set to expire at the same time. For example, the tax extenders, including some business tax breaks and limits on the alternative minimum tax, also would expire. About 4 million people pay the AMT, and unless Congress acts, the number could jump to about 28 million, according to the Tax Policy Center. That could add $3,700 a year in taxes to many payers’ bills.
Also scheduled to end is the holiday on the payroll tax. As part of the federal stimulus efforts, the payroll tax temporarily dropped from 6.2% to 4.2%. If that is not extended, the typical worker will have to pay an additional $1,000 a year in taxes.
Are there other issues?
There are always more issues waiting to be resolved. For example, the emergency unemployment benefits that have allowed out-of-work people to get money beyond the usual 26 weeks (or 39 weeks in high unemployment states), expire at the end of this year. There is also another increase in the federal debt limit needed in February. While not part of the fiscal cliff, the issues are among those on the table.
How do the parties want to solve the fiscal cliff?
Each side, Democrats and Republicans, has put out its initial proposal.
President Obama’s proposal, worth about $1.6 trillion over 10 years, is based on the idea of increasing the share of tax revenue paid by the wealthy -- individuals earning more than $200,000 a year and couples who annually earn more than $250,000. It would allow tax rates for the wealthy to rise to what they were before the Bush-era cuts, a change worth about $442 billion. It would also include changes to the value of some deductions, end breaks on capital gains and dividends, and raise taxes on estates and gifts.
Republicans have taken a different route, insisting that all of the expiring tax rates, including those for the rich, be extended. They seek to raise $800 billion over 10 years through curtailing tax breaks. They are also calling for more cuts in healthcare spending. By changing the way the inflation formula is computed, Republicans are also seeking to slow spending increases in programs such as Medicare and Social Security. The GOP proposal calls for $600 billion in cuts to healthcare programs, including an increase in the eligibility age for Medicare and more means testing to shrink health benefits for the more affluent elderly. (Obama has proposed $400 billion in Medicare and other savings.)
What are the politics, and how have they changed?
Think of the current political situation as two football teams lined up on the ball, which is on the 50-yard line. Each team’s position depends on whether they are playing offense or defense. Republicans argue that their proposal reflects last year’s talks, but Democrats insist it falls short of that and that, in any case, it no longer reflects the political landscape after the November elections.
Some of the possible compromises are similar to negotiations last year between the Obama administration and House Republicans -- talks that fell apart during the fog of electoral war.
A deal that Democrats might have accepted last year after Republican election successes in 2010 is not the same agreement that Obama will accept now after his reelection victory, his backers say.
Obama, and others in his administration, have insisted that he will not allow the Bush-era tax rates for the wealthy to be extended and that any deal depends on increasing marginal tax rates for the wealthy. The election, they say, gives the administration a mandate for forcing the rich to pay more. Other issues, such as cuts to Social Security, are not on the table right now, despite GOP insistence, they say.
What happens if the parties can’t agree and we go over the fiscal cliff?
In the short term, probably not very much since the world will not end at the beginning of the new year. However, longer-term, the parties are flirting with another round of recession. Cuts in government spending, coupled with higher taxes that decrease consumers’ purchasing power, usually mean a drop in production and a loss of jobs.
The Congressional Budget Office has projected that the economy would contract 0.5% in 2013, with the biggest shrinkage in the first half of the year. The unemployment rate is projected to rise to 9.1% by the fourth quarter.