The No. 1 issue on Capitol Hill these days is the so-called “fiscal cliff,” or the set of tax increases and spending cuts that will go into effect Jan. 1, 2013. A Congressional Budget Office Report issued this month projected that these provisions would save the government $448 billion next year alone, but that savings would come at the cost of slower growth and higher unemployment — throwing the economy back into recession and likely driving unemployment above 9%.
President Obama and Congressional leaders are eager to avoid such a scenario, but the two sides remain far apart on how they will divvy cuts in spending and tax hikes in such a way that doesn’t throw the economy back into recession. In addition, it is widely believed that for the President to win Republican cooperation on a deal, a tax and entitlement reform package would have to be included — meaning that a compromise to avoid the fiscal cliff could potentially be part of one of the most wide-reaching legislative packages in some time. And Congress has but six weeks to strike a deal.
If the enormity of this task makes you a little suspicious of Congress’ ability to tackle it, then perhaps you should prepare for taxes to go up in a big way in 2013. How exactly will “going over” the fiscal cliff cause you to pay more in taxes? Here are the three main components of the tax increases:
Expiration of the Bush Tax Cuts
President Bush and Congress enacted tax cuts in both 2001 and 2003. The 2001 cuts were in response to the budget surpluses (remember those?) that the U.S. Treasury had been accruing since the late 1990s. Additional cuts were enacted in 2003 to stimulate the economy from the 2002-2003 recession. But because these tax cuts were approved along party-line votes using the budget reconciliation process, they could only be enacted for 10 years. (Senate rules state that legislation that increases the deficit for more than 10 years requires a 60-vote majority to pass.) In 2010, the cuts were extended for two more years as part of a compromise that led to temporary payroll tax cuts and extended unemployment benefits. But they are set to expire once again in 2013. Everyone in Washington is in agreement that the tax cuts for those outside the top tax bracket should be extended, but absent a deal, every working American will be hit with a marginal tax rate increase of 5% on average, according to the Tax Policy Center.
(VIDEO: TIME Explains: The Fiscal Cliff )
Alternative Minimum Tax
The Alternative Minimum Tax sets a tax-liability floor of 28% for high-income earners. The problem is that the AMT is not indexed to inflation, so each year it ensnares more and more middle-income Americans. If the law isn’t “patched” by increasing the level of income at which taxpayers must pay the AMT, then tens of millions of taxpayers will owe much more to the government than they are used to owing, and they’ll owe that money retroactively for 2012. That’s right: if nothing is done to patch the AMT, you could find yourself with a much lower tax return, or even owing the government money when you file your taxes in a few short months.
Expiration of the Payroll Tax Cuts
As part of the 2009 stimulus package, President Obama and Democrats gave working Americans a “Making Work Pay” tax credit of $400 for working individuals or $800 for working families. But Republicans refused to extend that in 2010, so the president and Democrats replaced it with a temporary payroll tax cut, which lowered the rate workers pay in Social Security taxes from 6.2% to 4.2%. The measure was always intended to be a temporary method of stimulus, and the question was when it would expire, not if. Despite the still-convalescent economy, word came earlier this fall that both Democrats and Republicans in Congress were willing to let the tax cut expire. President Obama, on the other hand, wants to keep the measure or something similar — like a return of the Making Work Pay credit — in order to maintain support for the recovery. If something isn’t done, however, your taxes will go up by 2% of your gross annual income up to a maximum of $2,202 for those who make $110,100 and up. Single workers making $50,000 will take home $83 less each month.
Nobody knows what Congress and the president will agree to in the next six weeks, or if they will come to an agreement at all. But the law, as it stands now, is chock full of tax increases for earners both rich and poor. President Obama and Republicans in Congress have stressed their desire not to raise taxes on the middle class, but unless they can find a compromise on a broad range of issues, you should prepare to see your take-home pay drop in the new year.