Coming soon: ‘Taxmageddon’

The end of 2012 will be unlike any other time in memory for the government

YWASHINGTON – On Jan. 1 of next year, the federal tax bill for a typical middle-class household – making in the neighborhood of $50,000 – is scheduled to rise by about $1,750. This increase, which would come from the expiration of both the Bush tax cuts and the Obama stimulus, would follow a decade of little to no income growth for many people. As a result, inflation-adjusted, after-tax income for the median household could fall next year to its 1998 level, in spite of the continuing economic recovery.

The middle-class tax increase is just the beginning of budget changes set to take effect at the start of 2013. Poor families would see their taxes rise somewhat, too. Total federal taxes for top-earning families would rise by tens or even hundreds of thousands of dollars a year. Spending cuts would also take effect, squeezing domestic programs – education, transportation, scientific research – and the military.

All in all, the end of 2012 will be unlike any other time in memory for the federal government.

The tax increases and spending cuts are the result of Washington’s having previously kicked the can down the road, to use a phrase that is popular here. Rather than pass a plan to cut the deficit, policymakers have put off tough decisions. With the Bush tax cuts, lawmakers deliberately made them temporary, to avoid running afoul of budget rules intended to hold down the deficit.

Not surprisingly, leaders of both parties now say they are opposed to letting the changes happen on Jan. 1. Economists are also frightened of what such a sharp shift in government policy might do to a still fragile economy. Ben S. Bernanke, the Federal Reserve chairman, has referred to the various expirations as “a massive fiscal cliff.” Congressional aides, quoted in The Washington Post, call it “taxmageddon.” The problem, as always, is that the two parties cannot agree on what changes should take place. The combination – of political stalemate and potential economic cataclysm – will create an extraordinary period after this year’s election. A lame-duck Congress and President Barack Obama, either re-elected or defeated, will have less than two months to agree on an alternative plan, or the tax increases and spending cuts will take effect.

Optimists – yes, there are still some – say that the prospect of the tax hikes and cuts could finally nudge the two parties to the kind of deficit solution that many experts prefer. It involves sweeping tax reform that would close loopholes, reduce marginal rates, simplify the tax code and perhaps even lift long-term economic growth. Such tax reform has always been easy to put off, but the compromises it requires may end up being easier to accept than taxmageddon.

Ben Bernanke calls the tax expirations

‘a massive fiscal cliff’

et there is still a basic contradiction with which most politicians and voters have yet to grapple, the same contradiction that has helped create this strange situation in the first place. Talking in exasperated tones about the importance of fiscal responsibility is easy. Cutting the deficit is hard, because it involves unpopular tax increases or unpopular spending cuts – and huge cuts if the solution involves only spending, not taxes, as many Republicans urge.

Either way, the changes will affect the vast majority of Americans, given that the deficit reflects a basic disconnect between the government we have and the taxes we are willing to pay. Social Security, Medicaid and Medicare may become less generous. The Pentagon may no longer be able to get just about whatever it wants. Taxes may have to rise from their recent levels, which have been lower, as a share of the economy, than at any point in 60 years. That could mean higher rates. Or, if tax reform actually happens, it could mean smaller tax breaks for health care, housing and retirement savings.

The looming end of billions of dollars in popular government benefits may seem ridiculous. And the fact that Washington keeps delaying a serious deficit plan until another day may seem equally ridiculous. But they make perfect sense in a country where hypothetical solutions are a lot more popular than any actual ones.

Nothing highlights the paradox quite reform.

Most people seem to want tax reform. In a 2011 Pew Research Center poll, 59 percent of respondents said the tax code was so flawed that Congress should “completely change it.” Obama and Rep. Paul Ryan, the architect of the Republican budget plan, each claim to be more in favor of tax reform than the other one.

The notion of tax reform also has widespread support from economists, liberal and conservative. As they define it, reform would reduce marginal tax rates while eliminating or reducing various tax breaks. The tax code would then be flatter and simpler. Individuals and companies would not have to spend so much time and effort filling out their tax returns and figuring out which provisions helped them – an especially appealing notion this time of year.

Nobody knows for sure, but many economists

like tax believe that tax reform could lift economic growth, by freeing people to spend and work in the ways they think make the most sense, rather than in ways that happen to reduce their tax bill. Ryan’s plan would cut the top rate to 25 percent, from 35 percent, and still leave overall tax collection roughly where it has been, by eliminating tax breaks.

What’s missing from these plans is any detail on which tax breaks would be eliminated. Corporate lobbyists, like those at the Business Roundtable, offer an especially telling contrast: They urge the government to reform the tax code while continuing to push for loopholes that benefit them and generally refusing to name loopholes they would close.

The tax breaks that cost the government the most money turn out to be overwhelmingly popular. The three largest are those for health insurance provided by employers, mortgage interest and 401(k)’s. Corporate tax breaks are smaller, but the biggest corporate breaks are often popular, too, like the one for research and development.

“Tax reform is vital but difficult,” said Lawrence H. Summers, the former economic adviser to Obama and President Bill Clinton. “When people think of tax expenditures, they think of standing up to the oil industry. But a ton of it is things like IRAS.” He added: “The moment you start to look at the expenditures you’d eliminate, you’re struck by how much pain there is for modest rate reductions.” Optimists who believe tax reform could happen look to 1986, when President Ronald Reagan and a bipartisan Congress lowered rates and eliminated loopholes. However, there are at least two major differences between then and now. Most of the loophole closing in 1986 affected companies, not individuals. And policymakers spent months and months working together to put the law together.

None of that will be possible in the eight weeks between Election Day 2012 and Jan. 1, 2013. “Tax reform is a process, not an event,” said Donald Marron, a former aide to President George W. Bush who now runs the Tax Policy Center in Washington. Marron called full-scale tax reform “really unlikely.” What, then, will happen later this year?

Much will depend on who wins the presidential election. (Neither party is likely to have a filibusterproof majority in the Senate.) If Obama wins reelection, he and his aides say, he will not extend all the Bush tax cuts, as they agreed to do in 2010.

They instead plan to insist on a deficit plan that combines spending cuts with higher taxes for the affluent, who have received the largest tax cuts in recent decades. Obama, according to a senior adviser speaking last week, views taxmageddon as a chance to force the Republicans to acknowledge that even they do not support the spending cuts necessary to balance the budget without tax increases on the wealthy.

For the White House, the best case might pair an extension of the Bush tax cuts for several more months with a legislative framework for a new tax code that reduces tax breaks for the affluent. The top rate might not rise, but taxes on the rich would. Policymakers would work out the details in early 2013.

The so-called Buffett Rule, a focus of Obama’s last week, is a model for such a tax system. It does not specify which tax breaks would shrink for households with more than $1 million in income but rather caps the total value of such tax breaks. Martin Feldstein, a Republican economist, has proposed a similar cap for all taxpayers. The approach is meant to avoid a political war of attrition over every large, popular tax break.

Of course, Republicans have shown scant sign of wanting to compromise on high-end taxes, even after election losses, as in 2008. If they hold firm once again, Obama will have to choose between standing down (once again) and allowing taxes to rise on every household when the economy is still likely to be weakened.

Complete gridlock will include not only the expiration of the Bush tax cuts and the payroll-tax cut from the Obama stimulus but also a sharp increase in the Alternative Minimum Tax and cuts to national-security and domestic programs, prompted by Congress’ failure of last summer to reach a deficit deal. Together, the changes would reduce the deficit by more than 60 percent in the 2014 fiscal year, according to the Congressional Budget Office, but would inflict obvious pain.

With Mitt Romney in the White House and a Republican House, the uncertainty might be less. Unless congressional Republicans and a defeated Obama somehow came to a deal, they could wait for him to leave town before retroactively extending the Bush tax cuts, so long as they could win over a small number of Democratic senators. Republicans could likewise undo the Pentagon cuts.

To hold down the deficit, Romney and Congress could then cut domestic programs, including Medicaid, more sharply than Obama has. But recent history – both the Reagan administration and the second Bush administration – suggests that Republicans would probably not find enough spending cuts to offset their tax cuts and instead would accept larger deficits.

In the short term, it might not matter. The deficit is falling already, as the economy slowly emerges from the financial crisis, and foreigners remain happy to lend money to Washington at very low interest rates. Many economists think the state of the economy, not the deficit, is the bigger immediate problem.

Eventually, though, the deficit will start growing again, and sharply. The baby boomers are retiring, and health care is getting only more expensive. The era of falling taxes and growing benefits cannot last forever. The fiscal chaos that awaits at the end of this year is a preview of the choices to come.

– The New York Times

David Leonhardt is the Washington bureau chief of The New York Times.