The Fiscal Cliff: Some Basics

November 9, 2012

Since Election Day, there has been a lot of media coverage about the so-called "fiscal cliff," and state budget officers, like many others, are closely watching Congress and the Administration to see what will happen and how it will affect states. The "fiscal cliff" includes a number of tax and spending policies set to take effect under current law, including:

  • Expiration of numerous income tax provisions, including the Bush-era tax cuts, expanded tax credits under the Obama Administration, and many other temporary income tax breaks that are regularly renewed
  • Expiration of the two percentage-point payroll tax cut
  • Reversion of the Alternative Minimum Tax (AMT) income thresholds to 2000 tax year levels
  • Increased tax rates on earnings and investment income for high-income taxpayers under the Affordable Care Act
  • Automatic across-the-board spending cuts, known as sequestration, to nonexempt defense and nondefense programs
  • Expiration of emergency unemployment benefits
  • Reduction in Medicare’s payment rates for physicians

There is no question that "going over the cliff" (i.e., allowing all of the above spending cuts and tax increases to go into effect) can result in significant negative economic impacts. For example, Moody's Analytics forecasts that “going off the cliff” would dip the country into a mild recession beginning in early 2013 that could last six months. They forecast that the unemployment rate could be pushed back up over nine percent, and warn there are potential risks for an even deeper downturn. In addition, according to the Urban-Brookings Tax Policy Center, taxes will rise by roughly 20 percent if current law is not changed. The timeline for the fiscal cliff and other relevant dates that will shape budget negotiations is as follows:

  • December 31, 2012: Expiration of above-mentioned tax provisions
  • January 2, 2013: Sequestration cuts go into effect
  • Early 2013: Debt ceiling will need to be raised
  • March 27, 2013: Six-month continuing resolution (CR) expires

At this moment, predicting what will happen during negotiations is difficult, even with the election now behind us. However, most pundits seem to agree that the cuts under the sequester will not be allowed to occur. As for taxes, many experts believe that there is a strong likelihood that the payroll tax cut will be allowed to expire, although some Democratic Members of Congress have recently indicated that they would like the payroll tax to be "on the table" for negotiations. On the other side of the coin, many policy experts speculate that the Alternative Minimum Tax (AMT) will be fixed. If it’s not, many more Americans will have an unexpected tax bill increase when they file their taxes next year, since without a “patch” on the AMT, the income thresholds will revert back to 2000 tax year levels, thus pulling many more households under the AMT. That still leaves open the question as to what will happen with the expiring tax provisions often called the “Bush tax cuts.”

Some analysts think Congress needs to send the nation over the cliff temporarily and then deal with the tax issues and spending cuts in January, believing they can fix these issues retroactively. Yet, one expects there will be a lot of political pressure in mid-December for them to do something. NASBO staff thinks there will be a lot of public posturing and media attention over the next month and some agreement will be found by mid-to-late December. Congress will either find a way to delay some of the harder decisions or will actually come to some type of agreement. Getting a significant long-term deficit reduction deal during the short lame-duck period will be hard. NASBO will provide updates in our weekly Washington Report and through other means since at this moment, it's hard to speculate exactly what will happen. The more conciliatory tone of the debate since the election on Tuesday is heartening, but the issues here are complex and uncertainty continues. States are concerned about what, if any, federal budget cuts will occur, and how much the amounts will be. In addition, states are concerned about potential tax changes, their impact on the economy and the level of uncertainty federal actions will resolve.

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