Facing the Fiscal Cliff

By Shannan George
At some point in our education most of us have taken a class in civics or American government, giving us a good foundation for understanding the nation’s electoral process. The recent talk of recessions, bailouts and budget shortfalls has increased our desire to keep abreast of how the government spends its funds. The most current financial topic looming in the American consciousness is the “fiscal cliff” of 2013. As much of the discussion about this issue happened behind closed doors, what we know about the negotiations was reduced to debate and speculation.

That debate was resolved three hours before the Dec. 31, 2012, deadline when a deal crafted by Vice President Joe Biden and Senate Minority Leader Mitch McConnell was accepted. This so called “first fiscal cliff deal” addresses revenue (i.e. taxes) and averted the initial stages of an economic disaster. The deal also delayed automatic spending cuts and avoided the issue of raising the debt ceiling, setting the stage for additional budget deliberations in Congress and a second fiscal cliff deal.

However, with its official passing it is important to understand what the fiscal cliff deal means for individuals, businesses and families, especially in light of the uncertainty that preceded the deal.

Defining the Fiscal Cliff
“Fiscal cliff” is the phrase used to describe a financial perfect storm, the combination of an unprecedented number of expiring tax cuts and automatic federal spending reductions that were set to take place at the beginning of 2013. The combination of tax increases and new taxes was estimated at approximately $400 billion.

To inject life into a sluggish economy, the federal government has the power to increase government spending or decrease taxes. Falling off the fiscal cliff would have done the exact opposite and, if not averted, could potentially have sent our economy back into a recession. Frances Roberson, Ph.D., chair of Life University’s Business Department, describes the circumstances surrounding the financial cliff as “severe” and says that, “It would force compromise on spending and budget cuts by both Congress and the Office of the President.”

So how did we get to this point in our financial state of affairs? It seems that with all the governmental checks and balances, this scenario would be impossible. “The situation stems from previous congressional terms kicking the can down the road. That is, given the opportunity to address our bloated national debt, they instead opted to put a Band-Aid on the gaping wound and make minimal changes to fiscal policy as Congress controls taxes and government spending” says Joseph Maselli, economics and government instructor at Allatoona High School in Acworth, Ga.

Experts compare this financial crisis to the political gridlock that took place in the summer of 2001. At that time, Congress made an 11th hour decision to raise the nation’s debt ceiling. The more recent political infighting on the issue and ensuing fiscal instability caused Standard & Poor’s to downgrade the U.S. credit rating for the first time in history.

How the Fiscal Deal Will Affect You
Maselli explains that the implications of changes due to the fiscal cliff may “not immediately affect personal or business finances, as the decline’s aggregate demand will take time to respond to the higher taxes.” Leading up to the deal, the uncertainty on how the laws may change caused some businesses to delay hiring and caused many consumers cut back on spending. Many economists agree that in time the emotional, psychological and financial ramifications of the fiscal cliff will cause people to reduce spending, which could eventually slow economic growth. As a result of a reduction in consumption, layoffs may occur.

Emory law professor Dorothy Brown believes that had a deal not been made, small business owners would have suffered as “outside contractors, suppliers, consultants, won’t be able to continue to be hired. That will have a trickle-down effect to whomever depends on those contractors, suppliers, consultants, etc.,” she says. This trickle-down effect would mean an increase in the unemployment rate. Experts feared falling over the cliff would have elevated our unemployment rate—currently at approximately 8 percent—into the double digits.

 If President Obama and Congress had not reached an agreement by year’s end, the ensuing expiring tax policies would have negatively affected parents and employers as well. How the fiscal cliff deal breaks down for individuals, families and small business owners differs from how it will affect wealthier Americans.

The fiscal cliff compromise makes permanent tax cuts for individuals making less than $400,000 and couples earning less than $450,000. Americans whose income is over the threshold—including small business owners—will see their taxes rise from 35 percent to 39.6 percent. All other tax rates between 10 and 33 percent were set permanently into law. Economists estimate the increased taxes will raise more than $600 billion in new revenue over 10 years.

This is a welcome change for hundreds of thousands of small business owners, such as DCs, who would have been impacted if the threshold were set at $250,000 as suggested by President Obama. However, those individuals who are affected by the change are still seeking ways to lower their taxable income. Popular strategies include maximizing contributions to their retirement funds, matching employers’ contributions to 401(k) plans and incorporating businesses.

Family-owned businesses are also benefitting from the deal, which kept the estate tax exemption level at $5 million in assets for individuals and $10 million for couples. The deal also allows for annual adjustments for inflation. Had the compromise not been accepted, the exemption would have been lowered to $1 million. Another benefit for small businesses lies in the fact that the compromise allows for them to expense up to $500,000 of capital expenditures, like new equipment, instead of having to depreciate these purchases over time. Without action by Congress, the expensing limit would have dropped to $25,000 in 2013.

Another important change is in the Social Security tax, which is automatically deducted from workers’ paychecks. For 2011 and 2012, the share paid by employees decreased from 6.2 percent to 4.2 percent. The fiscal cliff deal did not extend this tax break, and workers saw the first paycheck of 2013 reduced due to the increase in taxes. Workers making the national average salary of $41,000 can expect to see $16 less each week, and some economists fear this may discourage job creation in the coming years.

Educational Expenses and Recent Graduates
During negotiations, the White House took the fiscal cliff debate to social media, including Twitter, to get citizens to voice their concerns. A recent college graduate posed a question to President Obama about how the fiscal cliff would affect her student loans. He responded that a plan that included tax cuts without revenue would equal reductions in student loans, work/study and the expiration of certain college tax credits. These credits included Bush tax cuts, the name given to laws designed to improve a then-bleak economic situation. The tax cuts included sunset provisions that caused them to expire in 2010. In order to encourage economic growth, these tax cuts were extended through Obama’s presidency.

Roberson highlights several Bush tax cut policies that, had they been allowed to expire, would have affected recent graduates and those paying (or repaying) education expenses, including student loans. Coverdell Education Savings Accounts is a tax-favored college payment plan created for the purpose of paying education expenses. If allowed to expire, the annual contribution limit would have decreased from $2,000 to $500 per beneficiary. The fiscal cliff deal made contribution limits permanent and will remain at $2,000. Reimbursements for employer-paid educational assistance were also set to be rescinded. This program, which allows up to $5,250 in tax-free education benefits from your employer each year, was extended permanently. Had a compromise not been met, deductions up to $2,500 in interest paid on student loans would have been limited to the first five years of interest payments. In addition, eligibility thresholds were slated to decrease from $155,000 for joint filers and $75,000 for singles to $75,000 and $55,000, respectively. Under the fiscal cliff agreement, this tax provision was made permanent, a welcome line item for millions of people repaying student loans. Congress also decided to extend the American Opportunity Tax Credit for five additional years. This credit allows families a tax break of up to $2,500 per year for college tuition.

How to Prepare for the Future
Roberson reminds readers that, “normally tax increases are scheduled for implementation to occur over a period of time.” Had Americans fallen over the fiscal cliff, billions of dollars in tax increases and cuts were set to occur in 2013. As Congress and President Obama ironed out the details of the new tax cuts and spending reductions, it was hard to say which policies would and would not have been affected and to what extent. Because of the unprecedented changes that were set to occur, it was impossible to predict how such changes would have affected each individual, business and household.

Many economists agree that, even though most of us were spared from the worst of the fiscal cliff, there is still much work to be done in Washington. Small businesses around the country are facing a new reality, one of uncertainty and concern. For DCs who own their practices, now more than ever it is important to understand the issues facing our lawmakers so that you can make informed decisions for yourself, your family and your business.