Uncertainty Reigns: The Election and the Fiscal Cliff

October 29, 2012

Michael Townsend
Vice President, Legislative and Regulatory Affairs, Charles Schwab & Co., Inc.

No matter how the November 6 elections turn out, Congress is slated to return to Washington on November 13 for a critically important post-election session to try to resolve the so-called "fiscal cliff" that looms on January 1, 2013—when taxes and spending cuts adding up to roughly $670 billion are scheduled to take effect.

These so-called "lame duck" sessions have become common in modern times, but the looming fiscal cliff means that this post-election session will be unprecedented in terms of the size and scope of the issues that need to be resolved.

The real work begins after the election

The phrase "fiscal cliff" has become shorthand for a confluence of events that will all take place at the end of this year if no agreement is reached. While the Bush-era tax cuts get most of the attention in discussions about the fiscal cliff, in our view, they're not the most important factor driving an agreement.

The reality is that those cuts could expire, and then the new Congress could reinstate some or all of them retroactively in early 2013. Generally, most taxpayers would not feel the pain of the increases until they filed their taxes in early 2014, giving Congress some wiggle room to wait until 2013 to address this issue. This isn't the preferred solution, but it could be done without too much disruption.

AMT—possibly the most pressing issue

The most-pressing components of the fiscal cliff are actually the federal debt ceiling, scheduled automatic spending cuts and a little-noticed but very important tax issue—the Alternative Minimum Tax (AMT). If the lame-duck Congress can forge a short-term compromise, expect those three items to be at the center of the agreement.

The AMT was created decades ago to ensure that the wealthiest filers paid their share of taxes. However, it was never indexed to inflation, so over the years it has captured more and more taxpayers. For more than a decade, Congress has been passing a series of "patches" that increase the amount of income that's exempt from the AMT, so the number of taxpayers paying AMT has remained relatively stable at four to five million.

The most recent AMT patch, however, expired at the end of 2011. If Congress doesn't fix it before the end of this year, as many as 30 million taxpayers will have to pay higher taxes via the AMT when they file their 2012 returns next spring. Congress likely wants to avoid that outcome, so patching the AMT will probably be part of any agreement reached this fall.

Beyond the AMT, the following are other key components of the fiscal cliff:

1. Bush-era tax cuts expire. The tax cuts approved in 2001 and 2003 are all set to expire at the end of 2012. If Congress doesn't act, the following changes will happen in 2013:

• Income tax rates will go up.
• The capital-gains tax rate will increase to 20%.
• Dividend income will be taxed as ordinary income.
• The estate tax will revert to a top rate of 55%, with an exemption amount of $1 million.

President Obama supports extending the tax cuts for taxpayers earning less than $200,000 (or couples earning less than $250,000), but letting them expire for higher-income filers. Republicans want to extend the tax cuts for everyone for one year and then make a serious run at comprehensive tax reform in 2013. This fundamental difference between the parties may be the most difficult sticking point in the negotiations.

2. The payroll tax cut expires. Two years ago, a temporary payroll tax cut was instituted, reducing the share of payroll taxes paid by employees from 6.8% to 4.8%. The rate is scheduled to return to 6.8% on January 1, 2013, and there seems to be little appetite for extending this temporary provision. Don't be surprised if the payroll tax cut quietly disappears.

3. Automatic spending cuts kick in. On January 1, automatic spending cuts known as the "sequester" are set to go into effect. The cuts total $55 billion in defense spending and $55 billion in non-defense spending. Many policymakers are concerned about the impact those cuts could have on a fragile economy. Lawmakers representing districts or states with significant defense installations or big defense contractors are particularly worried about the impact on jobs.

4. The debt ceiling increases. Sometime late this year or early next, the current debt ceiling of $16.4 trillion will be reached, and Congress will need to increase it to avoid a default by the United States. The last time Congress raised the debt ceiling was in August of 2011, when a difficult battle roiled the markets, rattled investor confidence and brought the country to the brink of default. No one in Washington wants a repeat of that scenario, but before they vote to increase the debt ceiling again, many lawmakers want to see real progress on deficit reduction.

5. Other tax provisions expire. Dozens of popular tax breaks expired at the end of 2011, and before 2012 ends Congress must decide whether to extend them, retroactively, to the beginning of this year. The list includes several business provisions as well as a variety of deductions for individual filers, including the IRA charitable rollover, which allowed individuals over the age of 70½ to roll as much as $100,000 from their Individual Retirement Account directly to a charity. Also on the list is the important AMT "patch" discussed above.

Looming over all of these "must-do" items is the need to take significant steps toward reducing the deficit. Lawmakers from both parties know this must be addressed, but the two parties have very different philosophies regarding how to go about it.

Uncertainty will continue

While there's endless conjecture about how the election will impact the resolution of the fiscal cliff, the simple truth is that no one really knows. Pundits who assert that a certain election outcome will produce one result while another outcome will produce a different result are just speculating.

If, as we expect, the election doesn't produce a clear-cut mandate for either party, it will increase the likelihood that the two sides try to forge a short-term agreement after the election that puts off the hard decisions until 2013, when the new Congress is in place. The odds of any kind of "grand bargain" that includes broad tax changes and significant deficit reduction are very low.

It could be well into December before we know how—or even if—the fiscal cliff issues will be resolved. So get ready for another several weeks of uncertainty.