In the famous 1955 movie Rebel Without a Cause, troubled high school student Jim Stark (played by James Dean) winds up playing a game of chicken with his classmates. The game is played as two teenage boys drive stolen cars toward a cliff. The first one to jump out of his car "chickens out," losing the game. Jim Stark jumps first, but his competitor gets his jacket stuck on the gear shift, is unable to jump out of the car and ends up going over the cliff to his doom. I cannot say that he won that game.
The U.S. economy is at risk of driving, so to speak, over a "fiscal cliff " starting January 1, 2013, an event that threatens to wreck the economy. The fiscal cliff got its name because under current law, there will be a massive and rapid tightening of fiscal policy in January unless Congress and the president agree to change the law before then. There are fewer than five months to avoid going over this cliff.
It is an election year, and Democrats and Republicans are locked in a battle royale as the Democrats aim to take back the House of Representatives while the Republicans aim to take back the Senate and White House. Each party has very particular and different proposals about what kind of adjustments should be made, or not made, to taxes and spending. Neither party wants the U.S. to go over the fiscal cliff, but election-year politics are not congenial to the type of political compromise necessary for a divided government to change the law. And so the political parties are acting much like the teenage boys in the movie, determined to be brave and strong and insistent that the other party make the concessions necessary to avoid going off the cliff. It seems unfortunate that current US politics resembles a dangerous game played by juvenile delinquents, but I believe that is what we have reached. In politics, as in the movie, the game might not end well.
If the U.S. economy goes over the fiscal cliff, the impact could be huge. The economy would probably slip back into recession, and with the unemployment rate currently close to 8%, the US can little afford another significant rise in unemployment. Going over the cliff could have profound-and not entirely predictable-consequences for the stock market, Treasury and corporate bond yields, commodity prices, and the U.S. dollar.
Below, I give the details about policies that contributed to the current predicament, what exactly the fiscal cliff is, what going off the fiscal cliff could do, and how the government may address the risk. To quote an old Russian proverb, "We should hope for the best but prepare for the worst."
How Did We Get Here?
The largest part of the fiscal cliff is the so-called Bush tax cuts, which were created by two pieces of legislation, called the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). These acts cut income tax rates, created new tax credits, raised certain tax exemptions, expanded depreciation allowances, restricted the Alternative Minimum Tax (AMT), and reduced estate taxes.
EGTRRA was signed into law by President Bush on June 7, 2001, as a fiscal response to the "tech wreck" that began in 2000 and pushed the U.S. economy into recession in early 2001. It was a sweeping piece of tax legislation that lowered income tax rates, revised exemptions and credits to reduce the "marriage penalty," phased out the estate tax, and extended and simplified retirement and savings plans.
The most notable feature of the tax law was a multi-year reduction in tax rates for each income tax bracket. In particular, by 2006 the 28% bracket would be lowered to 25%, the 31% bracket would be lowered to 28%, the 36% bracket would be lowered to 33%, and the 39.6% bracket would be lowered to 35%. The 15% tax bracket was left alone, but a new 10% bracket was created for low-income tax filers, and the 15% bracket's lower-income threshold was indexed to the new 10% bracket. To address the so-called marriage penalty in the income tax, EGTRRA raised the standard deduction for married couples filing jointly. Additionally, EGTRRA increased the per-child tax credit and the tax credit for spending on dependent child care, and phased out limits on itemized deductions and personal exemptions for higher-income taxpayers. The law expanded and simplified the rules for retirement plans (such as Individual Retirement Accounts) and for educational savings accounts (called 529 plans). Finally, the law gradually reduced the estate tax, eliminating it entirely in 2010.
It may seem odd that EGTRRA was set to expire in its entirety at the end of 2010, but Congressional budgetary rules impose a time limit on tax changes.
The recession of 2001 was one of the shortest and mildest in US history, but the recovery was relatively sluggish. The Federal Reserve Board (the Fed) eased to promote a better recovery, pushing its federal funds rate down to 1.00%, which helped start the housing boom. President Bush also requested another round of tax stimulus to boost the recovery, and Congress delivered. JGTRRA was signed into law by the president on May 28, 2003.
JGTRRA accelerated the gradual income rate reductions and the tax credit increases passed in EGTRRA so that instead of taking full effect in 2006, they took full effect immediately and were made retroactive to January 2003. In addition, the threshold at which the AMT applied was also increased. Finally, to reduce the double-taxation of corporate equity income, the tax treatment of capital gains and dividends was changed. Corporate income is taxed twice under current law, once because of the corporate income tax, and the second time because dividends and capital gains are taxed through the personal income tax. By contrast, the interest on corporate bonds is not doubly taxed because although it is taxed at the personal level, it is not taxed at the corporate level because interest paid is deducted in the calculation of corporate income. Many economists believe the double-taxation of corporate equity income has deleterious economic effects, including encouraging excessive corporate leverage, discouraging corporate investment, discouraging the payment of dividends, and inhibiting the efficient use of the corporate form of organization. The maximum tax on long-term capital gains was cut from 20% to 15%. "Qualified dividends"1 were no longer taxed as ordinary income; their maximum tax rate was also cut to 15%. The provisions of JGTRRA were scheduled to expire at the end of 2010 along with the provisions of EGTRRA.
Whether the Bush tax cuts were good or bad is a matter of opinion, but in the current election season, each political party's stance concerning their future is clear. For the most part, the Republicans believe they all should be extended, while President Obama campaigned in 2008 for repealing some, but not all, of the cuts-a view he still supports.
The AMT was created by the Tax Reform Act of 1969 in response to a discovery that 155 high-income households had paid no income tax through the aggressive use of tax benefits. The AMT was designed to require that everyone with a high income pay some income tax by capping the use of tax benefits. The AMT has been modified numerous times since 1969, but one important feature remains: the exemption amounts are not indexed for inflation. The result is that the AMT captures an increasing share of American households, many of whom are not high income. Moreover, the interaction of the AMT and the regular income tax is such that the AMT, if unmodified, would have offset some of the Bush tax cuts. Rather than make a permanent reform of the AMT, in recent years Congress has made a series of short-term "patches" to the AMT to limit its reach, patches that reduced federal revenue. The most recent AMT patch expired at the end of 2011, but Congress is considering renewing the patch for 2012. If it does, the new patch would expire at the end of 2012. In recent years, slightly over 4 million tax returns were subject to the AMT. If Congress does not continue its patches for the AMT, the Congressional Budget Office estimates that in fewer than 10 years, over 40 million tax returns would be subject to the AMT.
The U.S. faced an early version of fiscal cliff at the end of 2010, when all of the Bush tax cuts and the AMT patch were scheduled to expire. Many thought the economic recovery was weak and feared that the end of the Bush tax cuts would impose more fiscal austerity than the fragile recovery could withstand. After the elections of November 2010, President Obama asked Congress to extend the Bush tax cuts for the middle- and lower-income tax brackets but to allow the tax cuts on the high-income tax brackets to expire as scheduled, a policy he advocated during his campaign. Congress declined to implement President Obama's proposals.
Subsequently, the administration and Congress worked out a compromise. In December 2010, Congress passed and President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. That law extended all of the Bush tax cuts (including various tax credits, deductions and exemptions) through the end of 2012, renewed the AMT patch and extended emergency unemployment benefits through 2011. To boost household incomes further, the law also delivered for 2011 a two-percentage point reduction in the employee portion of the Social Security payroll tax (from 6.2% to 4.2% for paycheck employees and from 12.4% to 10.4% for the self-employed). To boost investment, qualified business capital spending was given more generous tax depreciation allowances; in particular, such spending was 100% tax deductible through the end of 2011 and 50% tax deductible through the end of 2012. Finally, the federal estate tax, which was eliminated for 2010, was due to return to its Clinton-era levels in 2011. The law allowed the estate tax to return but established a $5 million exemption and a maximum tax rate of 35% through the end of 2012.