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July 19, 2012
The Unnecessary Complication of the Fiscal Cliff

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By Caroline L. Harris

Caroline L. Harris is chief tax counsel and executive director of tax policy for the U.S. Chamber of Commerce.

In this article, Harris argues that Congress and President Obama should act quickly to extend the 2001 and 2003 tax cuts and other tax provisions before they expire at the end of 2012.

Harris is writing on her own behalf; her views do not necessarily represent those of the Chamber of Commerce or any other person or organization.

Caroline L. Harris Washington seems to be a town that loves complicating things. Thanks to last year's debt ceiling debate and the deficit reduction supercommittee, most of America now knows what sequestration is. It's easier to say "automatic spending cuts," but why make things simple? That mentality permeates even our weather forecasting. A few weeks ago, the D.C. region was hit by a derecho. Initially, I thought that was perhaps a failed car model from the 1970s. It turns out it is another word for "giant thunderstorm that demonstrates how incapable power companies are in dealing with emergencies."

And Washington is nothing if not consistent. The country is facing yet another matter that lawmakers seem hellbent on unnecessarily complicating -- the "fiscal cliff" or "Taxmageddon," or, as I prefer to call it, "the expiration of pro-growth tax policies combined with spending cuts that were never intended to go into effect and will crush any hope we have of economic recovery." Even I'm adding to the Washington complexity problem.

Much ink has already been devoted to what creates the fiscal cliff. The expiration of the 2001/2003 tax cuts, the end of alternative minimum tax patches, the expiration of jobs measures, the end of doc fixes, the expiration (or continuing expiration) of tax extenders, the implementation of healthcare reform taxes, and the implementation of the sequestration have created a fiscal scenario that threatens to kill the economic recovery. And we will have to address the debt ceiling again in early 2013.

The simple truth is that Congress and the Obama administration need to act now. The economy is still fighting its way out of a recession. Not one economic school of thought suggests it is a good idea to increase taxes when there is an 8.2 percent jobless rate. Christina Romer, President Obama's own former economic adviser, has concluded that "tax increases are highly contractionary." Even Obama himself has said "The last thing you want to do is raise taxes in the middle of a recession." There is no doubt that the country needs fundamental tax, entitlement, and spending reform, but falling off the fiscal cliff while we are trying to get to reform is like cutting off one's nose to spite one's face. In a word, it is ridiculous.

The ramifications of a failure to act are easily identified. First victim? Economic growth. A May 2012 Congressional Budget Office report concludes that "growth in real (inflation-adjusted) GDP in calendar year 2013 will be just 0.5 percent" and that "such a contraction in output in the first half of 2013 would probably be judged to be a recession."

A June 2012 report by Allen Sinai of the American Council for Capital Formation (ACCF) reiterates the negative impact of tax increases on economic growth, concluding that with the expiration of the 2001/2003 tax cuts on income and investments, real GDP growth will decrease 0.2 percent on average per year. That equates to a $529.4 billion decrease per year over the 2013-2021 time period. Sinai said that the results would be worse in the short run, finding that between 2013 and 2017, real GDP growth would decrease 1 percent on average per year, which equates to $669 billion.

Economic growth is not the only casualty. As House Ways and Means Committee Chair Dave Camp, R-Mich., has noted, tax increases "will turn the fiscal cliff into the jobs cliff." An April 2012 study by Douglas Holtz-Eakin of the American Action Forum finds, based on the CBO's GDP growth estimates and using the administration's own multipliers, that tax increases would result in the loss of between 300,000 and 2.9 million jobs. The June 2012 ACCF report says that the expiration of the Bush income and investment tax rates would hit particularly hard between 2013 and 2017, causing a loss of 2.8 million jobs on average per year.

The third victim? Businesses operating as passthrough entities. The explosion over the past 30 years of passthrough entities makes the effect of these tax increases even more daunting. According to the Tax Foundation, as a result of that growth, more business income is now taxed under the individual income tax than the traditional corporate tax.

The Tax Foundation calculated, based on 2009 data, that individual taxpayers earned $696 billion in net business income for that year. Two-thirds (66 percent) of that income was reported by taxpayers earning more than $250,000. The Joint Committee on Taxation determined that in 2013, a substantial share of new revenue (53 percent for the increase in the top two rates) will be attributed directly to the income reported for passthrough businesses by their owners, hitting approximately 940,000 entities. That is an increase from 2011.

The casualties won't stop there. The ACCF report finds that from 2013 to 2021, the expiration of the current tax rates will result in consumer spending losses of more than $1 trillion per year and business investment losses averaging $48.5 billion annually. The report concludes that with higher tax rates on income, capital gains, and dividends, saving will decrease on average 2.6 percent per year between 2013 and 2017.

Also at risk are retirees and those saving for retirement. Consider capital gains rates. In 2013 long-term capital gains rates will rise from 15 to 20 percent, the Pease limitation will raise the rate an additional 1.2 percent, and, thanks to healthcare reform, capital gains also will be subject to the Medicare health insurance tax, adding another 3.8 percent tax to capital gains and bringing the total tax rate to 25 percent. That is an increase of 67 percent from the 2012 rates on capital gains. Hardest hit are retirees and those saving for retirement; when last estimated by the Tax Foundation, they found a third of taxpayers reporting capital gains are over age 65; 40 percent of taxpayers reporting capital gains income are between ages 45 and 65, saving for retirement, and they earn 50 percent of all capital gains income.

If retirees and those saving for retirement earn dividend income, the pain is even greater. In 2013 taxes on dividends will skyrocket, rising from 15 percent to as much as 39.6 percent. Also, the same 3.8 percent Medicare health insurance tax and Pease limitations that hit capital gains affects dividends, bringing the tax rate on dividends as high as 44.6 percent -- an increase of up to 197 percent from the 2012 rate of 15 percent.

A May 2012 study by Ernst & Young finds that retired Americans and those saving for retirement rely on dividend income and thus suffer under those tax increases, like with increases on capital gains. Of returns filed in 2009 by taxpayers age 65 and older, 32 percent reported dividend income, while 63 percent of returns filed by taxpayers age 50 and older reported dividend income.

The reality is that failure to avert the fiscal cliff will be devastating to the economy, American businesses, and the American people. More organizations and leaders are acknowledging this daily. The IMF recently noted that the U.S. recovery remains tepid in light of "uncertainty over domestic fiscal plans" and stated that it was "critical to remove the uncertainty created by the 'fiscal cliff.'" Last month, the OECD stated that "legislative decisions are required to avoid the fiscal 'cliff' in 2013 due to the scheduled expiration of tax cuts and automatic spending cuts."

Those warnings echo statements by Federal Reserve Chair Ben Bernanke, who has repeatedly warned of the damage that inaction on the fiscal cliff could do to the economic recovery. Most recently he said that allowing the fiscal cliff to occur poses "a significant threat to the recovery," adding that "uncertainty about the resolution of these fiscal issues could itself undermine business and household confidence."

National Taxpayer Advocate Nina Olson warned last month that temporary code provisions add complexity and uncertainty, particularly when it is unclear whether a provision will be extended. She said that extending provisions late in the year exacerbates problems, particularly when the change is retroactive. Uncertainty affects not only IRS administration, she said, but also taxpayers' ability to plan, and she added that significant tax law changes late in the year cause many taxpayers to underclaim benefits because they are unfamiliar with the law.

On Capitol Hill, House leadership and the Ways and Means Committee have agreed to hold a vote before the August congressional recess to extend all the tax rates enacted in 2001 and 2003 and extended after a bipartisan compromise in 2010. In May 41 Republican senators wrote to Senate Majority Leader Harry Reid, D-Nev., asking him to take immediate action to stop the largest tax increase in history. Senate Finance Committee ranking minority member Orrin G. Hatch, R-Utah, has called on the president and Congress to act to protect families and businesses from "tax increases that will threaten America's weak economy."

Republican support for acting now has remained clear. Democratic concerns over inaction have recently begun to spike as the dangers of the fiscal cliff become more obvious. In early June, former President Clinton said, "What I think we need to do is to find some way to avoid the fiscal cliff, to avoid doing anything that would contract the economy now, and then deal with what's necessary in the long-term debt reduction plans as soon as they can."

Senate Budget Committee Chair Kent Conrad, D-N.D., a member of the so-called Gang of Six, has said it "might make some sense" to extend all the taxes in the short term if lawmakers need more time to reform the corporate and individual tax system. Other Democrats, such as Sens. Jon Tester of Montana and Joe Manchin III of West Virginia, have declined to heed their leaders' calls for a tax increase. Sen. Claire McCaskill, D-Mo., and Finance Committee member Bill Nelson, D-Fla., have refused to rule out support for an extension of all rates. Sen. Jim Webb, D-Va., has said that "we shouldn't raise [rates] on ordinary income," while Sen. Ben Nelson, D-Neb., has said he prefers "to extend the tax cuts for everybody." In fact, just last week, Democrats blocked an opportunity to even consider Obama's proposal to hike taxes on high-income earners. Perhaps Democratic leadership in the Senate should consider listening to members of their own party and act now to extend all current tax rates.

The reality is that Washington, the American people, American businesses, and much of the rest of the world will feel the damage if Congress and the administration fail to act now to avert the fiscal cliff. While some in Washington stand ready to act, others seem to cling to the need to unnecessarily complicate things, scheduling votes on bills that reflect election-year political messaging.

Now is not the time for Washington to make dealing with the fiscal cliff more complicated. It's time for action and simplification.

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