Tax increases and automatic spending cuts that take effect in 2013 will increase government revenue and significantly cut the budget deficit. However, that comes at the cost of economic conditions “that will probably be considered a recession.” That’s the conclusion reached by the nonpartisan Congressional Budget Office (CBO) in a recent report. The report also documents some of the factors and conditions that make addressing the situation so contentious. (Source: Congressional Budget Office , An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022, August 2012.)

Projections for the remainder of 2012

The CBO notes a modest expansion of the economy in the first half of 2012, and expects a slight increase in expansion during the last half of the year. Despite this economic expansion, the CBO does not anticipate any significant reduction in the unemployment rate, which the CBO projects to average 8.2% during the last six months of 2012. The CBO also anticipates continued low inflation and interest rates on federal borrowing. The CBO report specifically points out that projections for the remainder of 2012 reflect the view that “private-sector spending later this year will be limited by the specter of fiscal tightening and a looming recession in 2013.” In other words, even though the tax increases and spending cuts don’t take effect until 2013, we’re already feeling the effects.

What happens in 2013 (understanding the “fiscal cliff”)?

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 that expire at the end of 2012 include:

Lower federal income tax rates, part of the tax landscape for more than 10 years, return to pre-2001 levels beginning January 1, 2013. The top federal income tax rate will jump from 35% to 39.6%, and the maximum rate that applies to long-term capital gains will generally increase from 15% to 20%. Qualifying dividends, now taxed at lower long-term capital gain rates, will once again be taxed as ordinary income.
The temporary 2% reduction in the Social Security portion of the Federal Insurance Contributions Act (FICA) 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 (AMT) exemption amounts (the AMT-related provisions actually expired at the end of 2011) mean that there will be a dramatic increase in the number 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 (HI) portion of the payroll tax–commonly referred to as the Medicare portion–will increase by 0.9% for high-wage individuals, and a new 3.8% Medicare contribution tax will be imposed on some or all of the net investment income of high-income individuals.

CBO projections for 2013 and beyond

The CBO 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, this 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% in the second half of calendar year 2013, and remaining above 8% through 2014.

It is budget deficit considerations, in part, however, 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% of GDP by 2022.

What to expect

There seem to be only three 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. The third is that no one expects any real compromise or meaningful negotiation until after the November election.

If, as many expect, the issue is tabled until after the election, that will leave only a few weeks to reach agreement. The likelihood of action, and the form that any compromise might take, will depend in part on the post-election political dynamics. So stay tuned.

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