Fiscal Cliff for Dummies: Bush Tax Cuts, Sequester & More Explained

Sorry, I’ve been too busy buying wine for Thursday to pay much attention to this “fiscal cliff” everyone talks about. I need to stay warm camping out for Walmart’s 8 p.m. opening. So, what is it?

The “fiscal cliff” isn’t just one thing, it’s a bunch of tax rates and government spending levels that are scheduled to change on Jan. 1, 2013.

Umm, OK. What?

It’s easier to think of it as coming in two main parts. The first is the expiration of the Bush tax cuts. These tax cuts brought income and investment taxes down for everyone, with some of the biggest cuts coming for high-earners. The most contentious tax cuts that Democrats want to get rid off were for income and investment income at the top. The Bush tax cuts brought down the marginal rate for the highest earners from 39.6 percent to 35 percent. The maximum tax rate for income from long-term capital gains rate was brought down to 15 percent from 20 percent, and the tax rate on dividends dropped to 15 percent.

Back when they were passed in 2001 and 2003, they included a sunset provision, meaning they would expire at the end of 2010. President Obama cut a deal with congressional Republicans to extend the tax cuts for another two years in exchange for extended unemployment benefits and ++a 2 percentage-point reduction in the payroll tax++ [http://www.thedailybeast.com/articles/2012/11/15/the-fiscal-cliff-s-first-victim.html]. That extension, along with the payroll tax reduction, is scheduled to expire at the end of the year. That’s the first big chunk of the fiscal cliff.

And the second?

The second is the so-called sequester.

Sylvester? What does Rocky have to do with this?

No, no, sequester. This refers to one portion of the spending cuts included in the Budget Control Act, passed and signed in August 2011.

Does this have something to do with the debt ceiling?

Ding! Ding! Ding! Come on down and accept your prize of cuts in discretionary spending!

The Budget Control Act did three main things. First, it allowed the president to raise the debt ceiling by $2.1 trillion, thus making it possible for the government to increase its debts at least through this year. But more important, it instituted two rounds of significant spending cuts. The first was implemented “immediately.”

Why the scare quotes?

It was implemented “immediately” in a way only a Washington policy wonk could appreciate. Government programs whose budgets are set every year—defense spending, education funding, the FBI, and so on—would see those budgets collectively reduced, relative to their scheduled growth, by just more than $1 trillion over the next 10 years.

Wait, so is it a cut or a reduction in projected growth?

This is more of a philosophical question than anything else. Think about it this way: the revenue the government gets through taxes grows more or less along with the economy. So the status quo for the budget of a government program is that it will grow in real terms over time. Slowing down that projected growth means money can be freed up to be spent elsewhere. In the case of the Budget Control Act, the government would have to borrow less money to fund its operations.

But there’s a second part?

Yes, this is the sequester. The second portion of the cuts were supposed to be decided on by Congress.

A committee called the Joint Select Committee on Deficit Reduction was to come up with a list of cuts that would then be put to Congress for a full vote. If the committee, commonly referred to as the “supercommittee,” couldn’t agree on the cuts, $1.2 trillion in further spending reductions over 10 years would be implemented starting Jan. 1. This is the “sequester.” And combined with the expiring tax cuts—along with other annual tax and spending policies that are renewed every year, like adjusting the Alternative Minimum Tax so that it doesn’t hit too many people and maintaining the current Medicare payment rates for doctors—you have your fiscal cliff.

So what happens Jan. 1?

This is the $600 billion question. We know that, if nothing is done to prevent the spending cuts or tax hikes from coming into effect, the deficit will be about $600 billion smaller in 2013, meaning that $600 billion will be sucked out of the budget compared to 2012.

Wait, aren’t deficits bad? Don’t we want to shrink the debt?

Well, yes. Lots of people are concerned about the long-term mismatch between how much revenue the government brings in and how much money the government spends. Because of this disparity, the government has accumulated a debt of about $11.45 trillion and runs a yearly deficit of about $1 trillion. Even if we think that figure is something we have to deal with eventually, it doesn’t necessarily make sense to institute all these spending and tax hikes at once. The Congressional Budget Office estimates (PDF) that if we go completely over the fiscal cliff, the economy would shrink by 0.5 percent in 2013 and the unemployment rate would jump to 9.1 percent.

Are they right?

Well, something like that would probably happen. But only if we don’t do anything about it the entire year. Nothing all that special happens on Jan. 1. The federal government could probably push off the tax hikes and spending cuts for a few weeks, and if some kind of deal were reached, they could make the restored spending and tax levels retroactive for the entire year. No matter what, however, we’ll see some deficit reduction relative to this year.

We will?

Yes. Both sides support at the very least some kind of spending cuts—it’s the tax question that’s contentious. The Republicans would rather the Bush tax cuts stay as they are and that we cut spending to shrink the deficit, whereas Obama is insisting that the rich—individuals with more than $200,000 in taxable income and couples with more than $250,000—pay higher taxes as part of any deal to cut spending. If they can’t agree, we go over the cliff, the spending cuts and tax hikes kick in, and we get a whole lot of deficit reduction that no one really wants.

So we can avoid the fiscal cliff? If there’s some kind of deal?

YES! Some Republicans have made noise about accepting higher tax revenues from the wealthy, but nothing is set in stone. White House staffers and congressional Republican aides are set to meet this week. Maybe they’ll figure something out.

That would be the best Christmas gift ever!

And they don’t have to go to Walmart on Thanksgiving night to get it for us.