The Fiscal Cliff

Economystified reader Tim C. sent me a message via facebook that said simply "The Fiscal Cliff?"

Goodness yes, Tim...The Fiscal Cliff...

 Ten years ago…

In 2000, the Federal income tax schedule for a single person looked like this:

From MoneyChimp's interactive Fed income tax calculator

Keep in mind, this is not saying that if your taxable income was between $26,250 and $63,550, you owed 28% percent of your in taxes.  That’s not how the system works.

What it means is that any of your taxable income that falls into that range is taxed at the percent for that range.

So let’s say its 2000, you’re a single person with an income of $50,000 after all applicable deduction/exemptions (meaning you have a "taxable income" of $50,000).  You’re income tax bill would be calculated as such:

So a person with a taxable income of $50,000, under this tax schedule would pay $10,587.50 in income tax.  That number represents 21% of $50,000, not 28%.

If you need more of a refresher on income tax, see my previous post on the subject.

The Bush years

Between 2001 and 2003, Congress enacted a series of tax cuts that affected an array of rates and calculations, including Federal income taxation.  When the dust settled, that same single person now faced this tax schedule:

I know it’s not immediately obvious, but it is a decent cut in taxes.  Let’s revisit our example of a single person with $50,000 in taxable income.

So this individual’s income tax bill fell $1,277.50 between 2000 and 2003.

MoneyChimp.com has a great interactive Federal income tax calculator that lets you play around with different years and income levels, and test out how Fed income taxes have changed over the decade.  Take a minute to mess around with it, it’s worth the time!  

Now, these particular tax cuts (which are popularly referred to in the news as “the Bush Era Tax Cuts” or simply “the Bush Tax Cuts”) were set to expire on Dec. 31th, 2010.  That was the plan from the beginning: to make these cuts “temporary,” and revert back to the year 2000 rates on Jan 1st, 2011.

But here we are, its almost Dec of 2012, and what does the tax schedule look like?

Pretty much the same as it did in 2003, give or take a bit of pump up for inflation.  So the temporary tax cuts of the Bush years, that were supposed to be expired by now, are still the law of the land.  What happened?

The Recession Affect

In response to the financial crisis of 2006-7, and the recession that followed, Congress decided to extend the cuts beyond their Dec. 31st, 2010 expiration date. 

Remember, in our example, these tax cuts meant an additional $1,277.50 in the individual’s pocket per year.  With families already struggling, and unemployment very high, Congress felt it would be a bad move to increase people’s tax bills on top of everything.

So in 2010, Congress decided to extend the Bush Era Tax Cuts for an additional two years.  The new expiration date became Dec 31st, 2012.

Payroll Tax

Of course, so far we’ve only been talking about Federal income tax, which is just one of many taxes a citizen pays.  There’s plenty of others out there – sales tax, property tax,  capital gains tax, etc.

And let’s not forget payroll tax!  Every time a paycheck is cut in America, 6.2% of the worker's pay is taken in FICA taxes.  On top of that, the employer also has to come up an additional 6.2% of the check’s value from their own coffers for the FICA fund.  The FICA money is used to pay for Social Security and Medicare, the US’s two largest spending items.

Let’s keep going with our example worker.  I know we said he had a taxable income of $50,000, but let’s give him a “before-deduction’s” income of $55,000.

There’s 12 months in a year.  If he gets paid twice a month, that’s 24 paychecks received a year.  So each paycheck will be for $2291.67 ($55k / 24 = $2291.67). 

6.2% of each check goes directly to FICA.  That’s $142 per check.  The employer is also expected to come up with $142 for FICA.  So FICA receives a total of $284 when a paycheck is issued for this worker.

The money for Social Security and Medicare has to come from somewhere, right?  We’ve arbitrary set up this system for funding - one that triggers whenever a paycheck is cast.  We could collect FICA money anyway we want to, but this just happens to be the system we have going today.

The Obama years

Now, this system worked great when everyone is working, and when wages are nice and fat.  But by the time the recession was in full swing back in 2008-9, this was not the case.

And you can see how when money is tight, this system can be seen as an incentive not to hire people, and not to pay them high wages? 

You can see it almost as a “financial penalty” for having employees.  It’s a VERY small penalty, our guy's employer only pays $142 in tax for issuing a $2k check.  But it’s a penalty nonetheless.

So with wages dipping, and unemployment shooting through the roof, Congress decided in 2010 to temporarily “suppress” taxes on another front.  In addition to the extension of the Bush Tax Cuts (that is, the cuts to Federal income taxes), Congress "temporarily" reduced the payroll tax rate, dropping it from 6.2% to 4.2%.

Get a calculator and walk yourself through how that change would affect our example worker.  You’ll find his FICA tax bill fell from $142 per check to $96.25.  His employer saw the same drop as well.

But this measure was just meant to be temporary – to try to bring down the unemployment rates in the short term.  There’s no way we could make such a cut permanent, seeing how FICA funds our nation’s most costly activity – caring for seniors.

So when was this FICA (aka "payroll tax") cut set to expire?  Dec 31st, 2012.  That date sound familiar?

The Fiscal Cliff

So on Dec 31st, 2012, Federal income tax rates, and payroll tax rates are all set to revert to their old status overnight. 

The hypothetical employee we’ve been talking about would see his income taxes go up by more than a thousand bucks.  And at the same time, his payroll tax burden would jump from $96.25 back up to $142, an increase of $45.75.  That’s more than $1098 a year ($45.75*24 = $1,098).  All told, he's looking at a tax hike of about $2k.

Or from the worker's point of view, it’s going to feel like getting a roughly $2k reduction in yearly income.  That's a large reduction to have to take in one fell swoop.

Jumps of similar magnitudes will happen to all American workers.  It’s a nationwide pay cut, that will affect everyone and happen overnight.

This situation is what the press has termed “The Fiscal Cliff” or “Taxmageddon.”  It’s a concatenation of circumstances that many fear could sabotage the already fragile recovery, and tip us into another recession.

Why the Fiscal Cliff is already a problem

Ok, but that’s all the worst case scenario.  The Dec 31^st deadline is something that Congress is subjecting itself too.  If this comes down to the wire, they can always temporarily extend the current rates again and buy themselves more time to work this out.

What we’d like to see is a plan to gradually phase in any drastic changes in rates.  Or a plan to reduce govt spending/tax rates.  Or new mechanics for collecting taxes.  Let’s hope these are coming soon.

But here’s the thing that really bothers me about this whole mess.  This is a situation created entirely by Congress itself.  We’ve known the date of 'Taxmageddon' for ten years!!  And what’s the plan for how to handle it?  As of right now, there is none. 

Congress has done nothing but bicker about it for a decade.  The Republican’s resist a return to the old higher rates.  The Democrat’s say we must up taxes to properly fund the government.  Both parties want to see spending cuts, but for completely different govt functions.  Both have recommended alternative ways of collecting tax or financing programs, but neither party can get on board with the other’s plan.

If we were to go over the “Fiscal Cliff” – and payroll and Federal income rates all revert to their higher rates all at once – it can spark an entirely man made (and essentially avoidable) economic crisis!  Our own govt has become an economic liability!

Whether or not all this doomsday stuff happens (and I strongly believe it won’t) the fact that this has gotten this far is a huge issue.  Congress is having trouble managing govt finances right now.  And it’s not because of rules or problems imposed upon it from some outside power, or a force beyond its own control.  It’s because of its own dysfunction. 

Sure, times are tight and the weak economy limits Congress financial options.  It puts pressure on their resources.  But in my mind, that’s a reason to cooperate, not to just bunker down in the same old trenches harder than ever.

Fiscal Cliff: How Much Would Taxes Rise in 2013?

Tax Policy Center