Falling Off a Cliff? By Guest blogger Buck Klemkosky

Note from Larry -- I originally posted this article with an early draft. Please note below that I have inserted the proper and updated third paragraph. Apologies for excessive JD while on duty.

Falling off a cliff may be harmful to one’s health or even life if the cliff is high enough. In the U.S. a fiscal cliff looms in 2013 if Congress and President Obama do nothing between now and January 2, 1013. The fiscal cliff refers to the automatic tax increases and spending cuts that take effect in January 2013. Many believe that the combination of the tax increases and spending cuts will push an already slow-growth U.S. economy into a recession in 2013. The problem is that the U.S. has presidential and congressional elections in November 2012, and most of those up for re-election, including Obama, seem unwilling to address the fiscal cliff issue before the elections. After the elections, there will be a lame-duck Congress and perhaps a lame-duck president with little incentive to address fiscal issues. Many remember the U.S. debt ceiling debacle in August 2011 and anticipate the same political paralysis in addressing U.S. fiscal policy and the looming fiscal cliff.

The amounts involved in the fiscal cliff run into billions of dollars. The tax increases mostly center on the Bush tax cuts in 2001 and 2003, but also involve some of Obama’s tax cuts that will also expire at the end of the year. The Bush tax cuts were set to expire at the end of 2010, but were extended for two more years as a compromise in the last debt ceiling increase.

If the Bush tax cuts expire, the maximum individual income tax rate will increase from 35.0 percent to 39.6 percent, plus a recently enacted Medicare tax of 3.8 percent, for a new maximum tax rate of 43.4 percent. And this will affect not only high-income earners. The 10 percent income tax bracket will be eliminated and the upper levels of tax brackets will be 15 percent, 28 percent, 31 percent, 36 percent and 39.6 percent, up from 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent. So everyone will pay more income taxes if the Bush tax cuts expire at the end of 2012.

Almost half of those who file U.S. income tax returns do not pay federal income taxes. However, even these will pay more taxes. Obama had cut the employee share of the Social Security payroll taxes from 6.4 percent to 4.4 percent and this provision also expires at the end of 2012. Since everyone who works pays this tax, all income levels will be affected. For example, someone with an income of $50,000 will see his or her Social Security tax increased from $2,200 to $3,200. Additionally, the so-called marriage penalty, which had been eliminated by doubling the standard deduction for couples and adjusting tax brackets, will return. Limits on itemized deductions and personal exemptions will be reinstated, meaning more taxes for higher-income taxpayers. Change in the alternative minimum tax provisions may also result in more people paying higher taxes in 2013.

Investors and wealthy individuals will also pay more as the tax on dividends increases from a maximum today of 15 percent to 43.4 percent in 2013 – the same as the tax on income. The long-term capital gains tax goes up from 15 percent to 20 percent, plus the 3.8 percent Medicare tax for a 23.8 percent rate. The estate and gift tax goes up from 35 percent to 55 percent, and the estate and gift tax exemption amounts drop from $5.1 million to $1 million.

So tax increases will increase government revenues. On the expenditure side, mandated spending cuts will be triggered by the failure of the congressional “Super Committee” to reach a long-term deficit reduction plan in 2011. The committee could not agree on $1.2 trillion in deficit reduction over the next decade, so the automatic cuts to all non-entitlement programs will kick in next year. Most of the cuts will come out of the defense budget.

Adding up the tax increases and spending cuts amounts to approximately $435 billion or 2.75 percent of 2012 GDP of $15.8 trillion. As mentioned previously, many are of the opinion that this will create such a fiscal drag that it will certainly push the U.S. economy into a recession in 2013 if not before. Economic growth has already slowed to annual rates of 1.9 percent and 1.5 percent in the first and second quarters of 2012, precariously close to zero or negative growth.

Can there be a silver lining if the U.S. falls off the fiscal cliff? Certainly in the longer term. Including fiscal year 2012, the last four federal budget deficits have each been more than $1 trillion and averaged 8 percent of GDP. The $5 trillion in accumulated deficits don’t appear to have helped the economy that much. The accumulated growth since the recession ended in June 2009 has been 7.1 percent, the weakest of all the post-World War II recoveries. The last three economic recoveries have been below par, but this one is the worst three-year performance to date.

So where is the silver lining? Since deficit spending has not stimulated a strong economic recovery, the $435 billion of tax increases and spending cuts may not be the Armageddon many fear. And they may rectify federal budget deficits that are not sustainable in the long run. This fiscal year, ending September 30, U.S. tax revenues are estimated to be $2.46 trillion or 15.7 percent of GDP, while expenditures are estimated to be $3.6 trillion or 23.4 percent of GDP. The projected deficit of $1.1 trillion means that only 68 percent of expenditures are funded by tax revenue. The rest, 32 percent, will be covered by the issuance of debt. Eventually bond investors are going to say, “Enough is enough,” and demand higher interest rates to buy U.S. Treasury securities. Historically low interest rates have helped the U.S. finance its deficits; much higher rates could be a catastrophe. So going over the fiscal cliff could help the U.S. get its fiscal budget under control on a sustainable long-term basis.

Resolving the fiscal cliff question as soon as possible may be more beneficial to the U.S. economy than whether we go over or not. The  uncertainty of the outcome has already affected corporate investment decisions and consumer spending. Less uncertainty will go a long way in helping the economic recovery. Too bad politicians don’t think that way.