Edging Toward the Fiscal Cliff, Tax Increases Inevitable

by Lowell L. Kalapa, Tax Foundation of Hawaii

No matter the political rhetoric you will hear in these final weeks before the general election, there is no doubt that there will be an increase in taxes at the federal level.

As a result of being unable to come to an amicable compromise last year on the level of federal spending or reductions in federal spending, federal lawmakers bought into a “do or die” proposition that will automatically kick in on January 1, 2013 - unless of course the lame duck session of Congress chooses to “kick the can down the road” again. The proposition is that there will be an automatic reduction in federal spending of more than $1 trillion or about the price tag of running the federal government for one fiscal year.

Given the horror facing lawmakers with the passage of the end of the federal fiscal year on September 30th, there is no doubt that Congress will resort to raising revenues to address, in part, this mandated reduction in federal spending. Although the simplistic approach is to merely raise rates, much of the controversy will involve whether or not to terminate or modify the so-called “Bush tax cuts.”

So what are the “Bush tax cuts” that will be on the table? As noted above, the easiest way to raise additional revenues is to raise rates. Under the current law, very low-income individuals subject to the federal income tax pay a 10% tax rate. This lowest rate probably would disappear. At the other end, middle and high- income individuals will probably see a rate increase of three percentage points with the top rate rising from the current 35% to somewhere around 39%.

The preferential rate granted to long-term capital gains of 15% will probably rise to 20%. This is the tax used to criticize financial wizard Warren Buffet who more than likely realizes all of his annual income in long-term capital gains taxed at the lower 15% rate while his secretary probably paid a 35% rate on her salary because it was “ordinary income.”

Similarly, income from dividends earned on equities or stocks have enjoyed the preferential rate of 15%. It is more than likely that this form of income will be taxed at “ordinary income” tax rates where the maximum rate would be around 39%. There is no doubt that the higher taxation of long-term capital gains and dividend income will have a profound impact on the stock market as investors move from this type of income to others that would have a preferential rate or be exempt all together like municipal bonds.

Deductions for certain types of expenses will also come under fire as deductions reduce the amount of income exposed to income tax rates. College graduates have enjoyed the ability to deduct the interest on their student loans for an unlimited amount of time and were disqualified for this deduction at very high-income levels. It appears that the Congress will set a time limit on how long the interest payments will be deductible and set much lower limits of income when the deduction will disappear. And there is no doubt Congress will go back to considering limiting the amount of itemized deductions for those in higher-income brackets. This latter provision will, no doubt, throw a curve into the charitable community which depends on wealthy individuals sharing some of that wealth with worthy causes.

Some of the more popular tax credits, such as those for childcare and education, will be severely curtailed and the amount that can be claimed substantially reduced. Tax credits are certainly a big target as they represent a dollar-for-dollar reduction in tax revenues unlike deductions that merely reduce the amount of income that will be subject to the federal tax rates.

However, the one possible change that has sent lawyers and accountants into a virtual tizzy is the resurrection of the federal “estate and gift” tax law that may revert to those amounts imposed before the “Bush tax cuts” which means moving the maximum tax rate to a maximum of 55%, up from the current maximum tax rate of 35%, and the estate tax exclusion could revert back to the $1 million amount pre Bush era which would be down from the $5 million plus amount currently available to estates.

Therefore, taxpayers should recognize that if Congress does not have the political will to cut federal expenditures as mandated by current law, they will be coming after your pocketbook. If taxpayers want to avoid yet another tax increase, then spending has to be cut. While there could be a combination of both tax increases and spending cuts, either will have to be substantial to conquer that $1.3 trillion target.

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