As we prepare to ring in 2013, will it be curtains for the US economy or will politicians set the stage for a new era of compromise? That’s the burning question in the minds of many Americans. The fiscal cliff—the “it” metaphor used to describe the nation’s expiring tax breaks and spending cuts—has created a lot of uncertainty among business leaders and investors. However, it’s important that people understand that the war of words being waged in the press is not reflective of what’s really going on at the bargaining table. Most of what we’re seeing is pure public theater.
The two lead roles are being played by President Obama and Speaker of the House John Boehner (R-Ohio.) Behind the scenes, their differences are really not that great. Last Friday, departing from Republican orthodoxy, Boehner offered to increase tax rates for people making more than $1 million per year. President Obama made a counter offer on Monday to raise taxes on people making more than $400,000, a softer stance than his original proposal of raising taxes on people making more than $250,000.
There will be a lot of negotiating with both sides pretending to walk away and consult with their managers, the Democratic and Republican caucus members, who will encourage a tougher stand. Ultimately, both sides will relent in the interest of a deal that protects them from political blame if things go wrong.
My instincts tell me that the new higher marginal tax rate will end up being 37% or 38% on top of the 3.8% income tax that was enacted under the Affordable Care Act. The rumor inside the Beltway is that the tax rate for capital gains and dividends for upper-income individuals will rise from 15% to 20%, and I think that is likely to occur.
What is less known is what’s going to happen to the gift and estate tax. If unaltered, any estate worth more than $1 million will be subject to the estate tax, to a top rate of 55% next year, before passing to family or other heirs. Currently the ceiling is 35%. The net impact is that the number of estates affected could rise from less than 4000 to 55,000 next year. But I anticipate a compromise that will roughly extend the current tax rate with a few slight modifications.
There’s also a lot of uncertainty surrounding limitations on deductions and other tax preference for upper-income individuals. This was the starting point for Speaker Boehner, although he never provided details on exactly how it would work. During the presidential campaign Gov. Romney proposed to limit the deduction to as little as $17,000. This is one area where the president and congressional Democrats are probably a little closer to the Republicans. While upper-income individuals, who tend to lean toward Republicans, would bear the brunt of it, many of them live in heavily taxed states like California, New Jersey, New York and Massachusetts, where the costs of homes are also very expensive. However, these are predominantly Democratic states which might hurt them if deductions are severely limited. I suspect that a logical resolution might be adopting a proposal, first introduced by Obama a few years ago, that limits deductions to 28% instead of the new top rate of above 37%.
The biggest guessing game is on the treatment of income received from state and local government bonds, which is currently tax exempt. While more of the benefits flow to the wealthy, eliminating or significantly limiting their tax-free treatment would raise the cost of borrowing for local and state entities.
Both sides will have to swallow things they do not like, which will anger their party base. Here, the president has an advantage in that he was both re-elected and he is the undisputed head of his political party. Boehner has to deal with many different factions of the Republican party, making his task more difficult. The good news for him is that even the Tea Party got a wake-up call during the election that all is not well. Some of them are beginning to understand that serving in government involves governing and not just lobbing hand grenades. Helping Boehner, a decent guy with a very difficult job, is the fact that absent an agreement, taxes for all Americans will go up. That will put blame squarely on Republicans and that’s not something they can afford to let happen.
The real obstacles for the president and Boehner will be agreeing to a package that raises $1 trillion to $1.1 trillion over the next two years. President Obama and congressional Democrats will have to succumb to Republican demands that spending be cut equitably. Where those cuts take place remains to be seen, but the president has irritated some Democrats by saying he would be amenable to changing the way that inflation is calculated in entitlement programs. Boehner has moved away from earlier proposals to raise the Medicare eligibility age from 65 to 67. What is open for discussion is greater means testing for Medicare recipients, which would require wealthy individuals to pay some variation of higher taxes or insurance premiums.
Another area of apparent retreat for the president is the extension of the payroll-tax holiday, which was not included in his last offer. Republicans have also moved away from their previously strong position opposing the extension of unemployment insurance for people who have been out of work for more than six months. This is another area where I could see a compromise. People who have exhausted their unemployment benefits might get an extension, but it could be come with a reduction of their individual benefits.
Also on the table will be the extension of the debt ceiling which is scheduled to expire by the end of January. In August 2011, President Obama was compelled by House Republicans to accept a lot of reductions in spending in exchange for their vote. Rank-and-file Republicans do not want to lose this leverage while the president is anxious to avoid another protracted battle on top of the fiscal cliff ahead of his Jan. 20 inauguration. President Obama drew a line in the sand but has since retreated. On Monday Dec. 17, he said he could live with a two-year extension. Meanwhile, Speaker Boehner has said that he might be amenable to a proposal that would get the nation through another year. I expect the Boehner proposal to be adopted.
Expect theatrics until the end, which may be Jan. 2 or just before the new Congress is sworn in. Democratic activists will continue to argue against budget cuts that harm the poor. Meanwhile, Republicans will lament the fact that raising taxes on businesses will hurt economic growth and that more entitlement-spending reductions must occur to restore the nation to fiscal sanity. This is not a new tune.
So far, Boehner has not faced a major backlash within his own ranks. His recent “Plan B” to allow taxes to rise for only individuals making more than $1 million cannot pass the Senate, and he might even lack enough votes to pass it on the House floor. More than anything, it is a tactical proposal designed to place more pressure on the president to make further concessions to their budget negotiations. At the same time, it emphasizes to his reluctant Republican troops that they could accomplish far more with a broad agreement than a unilateral action. Budget cuts and moderate tax increases are modest concessions when the alternative is the Bush tax cuts expiring with no significant modifications to the nation’s entitlement-spending programs that are threatening the nation’s long term solvency.
This is only the second chapter in the book about how America reluctantly dealt with its fiscal condition in this decade. It comes at a time when a massive number of baby boomers are collecting retirement benefits from a federal government that cannot afford its obligations. The fiscal cliff will bring positive—albeit modest—results. The inevitability of recurrent annual deficits of more than $1 trillion will compel a harder discussion and more difficult solutions in the coming chapters.