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Dooley: The economic impact of the fiscal cliff

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The failure of the deficit reduction supercommittee to reach an agreement in November 2011 automatically triggered $1.2 trillion in broad-based spending cuts over a multiyear period beginning in 2013 (the official term for this is “automatic sequestration”). The automatic cuts will be split evenly between defense spending and nondefense spending. In addition, a number of significant tax breaks expire at the end of 2012.

The expected economic impact of the combination of mandatory spending cuts and tax increases has been deemed by many the “fiscal cliff.”

Significant tax provisions expire at the end of 2012.

Lower federal income tax rates, part of the tax landscape for more than 10 years, return to pre-2001 levels beginning Jan. 1. The top federal income tax rate will jump from 35 percent to 39.6 percent, and the maximum rate that applies to long-term capital gains will generally increase from 15 percent to 20 percent. Qualifying dividends, now taxed at lower long-term capital gain rates, will once again be taxed as ordinary income.

The temporary 2 percent reduction in the Social Security portion of the Federal Insurance Contributions Act payroll tax, in place for the last two years, will no longer apply.Current rules relating to the federal estate and gift tax expire (exemptions will substantially decrease, and the tax rates will substantially increase).

Lower alternative minimum tax exemption amounts (the AMT-related provisions actually expired at the end of 2011) mean that there will be a dramatic increase in the numbers of individuals subject to AMT when they file their 2012 federal income tax returns in 2013.

Also beginning in 2013, two new taxes take effect. The hospital insurance portion of the payroll tax – commonly referred to as the Medicare portion – will increase by 0.9 percent for high-wage individuals, and a new 3.8 percent Medicare contribution tax will be imposed on some or all of the net investment income of high-income individuals.

The Congressional Budget Office projects that as a result of currently scheduled policy changes, including the tax increases and spending reductions that take effect in 2013, the budget deficit will drop significantly. According to the CBO, however, the fiscal tightening will likely lead to a recession. The CBO expects growth in GDP to decline in 2013, with the unemployment rate rising to about 9 percent in the second half of calendar year 2013, and remaining above 8 percent through 2014.

It’s budget deficit considerations, in part, that make reaching agreement on action so difficult. Extending lower tax rates and other popular tax provisions might help in the short term – potentially preventing the projected recession – but would, the CBO says in its report, “boost deficits and debt significantly and would place the budget on a path that is ultimately unsustainable.”

Under an alternative fiscal scenario evaluated by the CBO (in which most of the expiring tax provisions are extended and the mandatory spending cuts do not occur), the economy in 2013 would be stronger, but deficits over the next 10 years would be much higher in comparison; outlays would consistently outpace revenues, and debt held by the public would climb to 90 percent of GDP by 2022.

There seem to be only two things that all parties agree on. The first is that something should be done to prevent the automatic spending cuts from going into effect in their current form. The second is that at least some of the expiring tax provisions should be extended.

There are only a few weeks to reach agreement. My guess is that the bipartisan bickering continues right down to the end – which is ridiculous. And in the end, they’ll just kick the can a little farther down the road; really pretty pathetic isn’t it?

Merry Christmas and here’s to a new year in which our friends in Washington accomplish something. Stay tuned.

• Timothy J. Dooley , a certified financial planner, is president of Comprehensive Retirement Resources Inc., an Independent firm in Woodstock; phone 815-337-4217. He offers securities through Raymond James Financial Services Inc.

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