This is the first in a series of posts examining in detail the components of the so-called fiscal cliff.
The "fiscal cliff" was born more than a decade ago. President George W. Bush's first package of tax cuts in 2001 came with a sunset clause of 10 years. Follow-up legislation passed in 2003 was also scheduled to expire at the same time.
On Jan. 1, 2011, tax rates on income, capital gains, dividends and estates were to revert to those under President Bill Clinton. But in 2010, President Barack Obama extended the Bush tax cuts for two more years, pushing their expiration date to Jan. 1, 2013.
How big an effect would the tax cuts' expiration have in fiscal, economic, distributional, political and social terms?
The Bush Tax Cuts
Bush's 2001 law reduced marginal income-tax rates across the board. The top rate was scaled back from 39.6 percent to 35 percent. The 36 percent, 31 percent and 28 percent brackets fell by three percentage points. The 15 percent bracket on the lowest incomes was split into two to include a 10 percent bracket at the lower-income end.
It doubled the child tax credit from $500 to $1,000 and made it refundable -- that is, it would still count if it resulted in a negative income-tax liability. It also increased the dependent-care tax credit: One could deduct up to 35 percent of expenses to a maximum of $3,000 per child for no more than two children, compared with a previous limit of 30 percent of expenses up to $2,400 per child.
The law also eliminated the threshold incomes above which personal exemptions and itemized deductions are phased out, and sought to reduce the so-called marriage penalty in the income-tax code by making the size of the standard deduction for married couples double that for singles. And it changed the calculation of the earned income tax credit in a way that further lowered the marriage penalty.
The legislation also made significant changes to the estate, gift and generation-skipping transfer taxes. It scheduled gradual reductions of these maximum tax rates from 55 percent to 35 percent in 2010 and repealed the 5 percent surtax on estates larger than $10 million. Beyond this, it increased the minimum threshold needed for estate tax and generation-skipping tax eligibility from $700,000 in 2002 to $3.5 million in 2009, finally abolishing them entirely in 2010. It also raised the lifetime exemption on the gift tax to $1 million.
Bush's 2003 tax-cut package accelerated many of the original law's tax changes. It also eliminated the long-term capital-gains tax on individuals and couples in the two lowest marginal income brackets, and the 20 percent capital-gains tax bracket fell to 15 percent. And it eliminated the capital gains tax treatment for assets held longer than five years, folding it into the standard long-term rate, which is accessible at one year. Qualified dividends shifted from tax treatment as ordinary income into capital gains.
Going over the fiscal cliff would result in the expiration of all the above changes to tax policy, with an immediate reversion to the income, estate, gift, generation-skipping transfer, capital-gains and dividend tax rates last seen under Clinton. This would mean a huge increase in tax revenue, $325 billion over the next two fiscal years, according to a Congressional Research Service report.
Some provisions, however, have put more of a dent in the budget than others. The 10 percent tax bracket for the lowest incomes alone will cost $80 billion over the next two years; the cuts to other income-tax rates are worth $95 billion. Smaller provisions include the child tax credit ($40 billion) and its refundability ($10 billion), the estate-tax cuts ($35 billion), the capital-gains and dividend tax cuts ($25 billion), the elimination of the personal exemption and itemized-deduction phase-outs ($20 billion), and the "marriage penalty" fixes ($10 billion).
Looking more closely at the cost of the income-tax provisions in 2013, the cuts to upper-income brackets are worth $52 billion, to middle-income brackets $84 billion, and to lower-income brackets $55 billion, according to an Economic Policy Institute study. Over the long term, allowing the 2001 tax cuts on upper-income-tax brackets to expire may increase revenue by $297 billion over the next five years and $824 billion over the next 10, according to the Congressional Budget Office.
If the Bush tax cuts are not extended, the economy would contract by $281 billion in 2013, Moody's Analytics Inc. Chief Economist Mark Zandi forecasts. That would mean a net 1.8 percent decrease in the level of gross domestic product.
These numbers suggest the U.S. would narrow its budget deficit considerably with a relatively limited short-term effect on the economy. That is because the fiscal multiplier on the 2001 and 2003 tax cuts, which measures the "bang for the buck" in economic output from net government spending, is low compared with the other forms of spending cuts and tax increases in the fiscal cliff.
The tax cuts on the top incomes would have substantially less impact on the economy than the tax policies that affect lower-income Americans. Allowing just the top-end cuts to expire would reduce GDP growth in 2013 by 0.1 percent and total employment by 200,000, according to the CBO. That represents $40 billion in lost economic activity, compared with the $174 billion provided by the cuts that benefit the middle class and the poor, according to Zandi. (Those policies include the earned income tax credit, the child and dependent care tax credit, the changes to the 10 percent and 15 percent marginal income-tax brackets.)
The Bush tax cuts were sharply regressive -- that is, people with high incomes benefited far more as a percentage of their income. The expiration of the cuts would be correspondingly progressive, with large increases in the tax burden on high-income and wealthy families and individuals.
If all the tax cuts were allowed to expire, after-tax income of the lowest income quintile will fall 0.5 percent, and the middle-income quintile's income will decline 2 percent. For the top-income quintile, however, after-tax income will fall by $7,119, or 4.1 percent. And the top 1 percent by income bears the brunt of the change, paying an extra 6.4 percent of income, or $70,746.
Allowing the 2001 and 2003 tax cuts to expire would be, in large part, a win for Democrats. The party's platform calls for reverting to the top two income-tax brackets under Clinton -- 36 percent and 39.6 percent -- while preserving the rate reductions for the lower brackets. Limits to personal exemptions and itemized deductions are another part of the Democratic plan, coming in at $200,000 in income for individuals and $250,000 for married couples. The top capital-gains tax rate would rise to 23.8 percent, due to an additional 3.8 percent levy in the Affordable Care Act.
Democrats, however, do not want to see it all go. They have voiced support for continuing the expanded child and dependent tax credits and the earned income tax credit. President Obama has proposed to let the estate tax revert to its 2009 level, with estates valued at more than $3.5 million subject to a top rate of 45 percent. (That would be more generous than a reversion to the Clinton-era estate tax.) He also pledged in 2008 to continue current tax treatment of married couples to avoid the return of the "penalty."
Republicans have far more at stake in this part of the fiscal cliff -- namely, the tax-cutting legacy of President Bush. They would like to preserve all of the income-tax cuts, and it is likely they would continue to favor the expanded child and dependent tax credits as well as the earned income tax credit and "marriage penalty" fixes. They also appear to support a continuation of low rates on capital gains, dividends, estates and gifts. The Republican Party may be more amenable to a return of the limits to personal exemptions and itemized deductions. This is far from certain, however: A bill by Representative Dave Camp, the current chairman of the House Committee on Ways and Means, would not return those limits.
No millionaires will end up in soup kitchens as a result of the expiration of the Bush tax cuts. But lower- and middle-income couples with children are at risk of a substantial increase in their tax burdens, given the cumulative effect of the earned income tax credit, "marriage penalty" fixes, and the child and dependent care credits. Though this risk is hardly comparable to some other parts of the fiscal cliff, it may present some social problems at the margin.
(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)
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