Taxmageddon: Is the Fiscal Cliff an Economic Doomsday?

 

Takeaway

  • A series of automated federal spending cuts and tax increases is set to take effect Jan. 1
  • Economists worry that the Fiscal Cliff could trigger a recession if a deal is not reached in time
  • Eliminating certain deductions and scaling back entitlement programs could ease the burden

As 2012 ticks down to its final days, it’s not just buffs of the Mayan calendar who fear the end of the world as we know it. 

Assuming doomsday does not arrive Dec. 21, the nation could face another apocalyptic scenario just 11 days later. Some economists call it Taxmageddon and others the Fiscal Cliff — a half-trillion-dollar smorgasbord of expiring tax cuts, along with benefit and budget cuts, that start kicking in on New Year’s Day. They warn it could topple the U.S. economy back into recession. 

While President Obama and leaders of both parties bicker over a deal to avoid the cliff, Texas Enterprise asked three tax and finance professors at the University of Texas at Austin to give them a little help. Some of their suggestions:

How to Raise Taxes 

Ending Bush-era tax cuts for couples making over $250,000 a year, as Obama proposes, “will not make a dent in the problem,” says Sandy Leeds, distinguished senior lecturer on finance at the McCombs School of Business. 

The Congressional Budget Office estimates such a move would raise $42 billion in 2013, while extending the tax cuts for everyone else would add $288 billion to the deficit.

A more effective way to raise revenue from the wealthy is to restrict their favorite tax exclusions, argues Calvin Johnson, professor at the School of Law. “The taxable income of the richest reflects almost none of their standard of living. If you increase the tax on zero by 100 percent, you still get zero.”

Johnson has a hit list of 64 deductions that, if eliminated, would save taxpayers a total of $1 trillion. But he spotlights several that benefit mostly the wealthiest Americans:

  • Capital gains other than stocks – currently taxed at a maximum of 15 percent – should be taxed as ordinary income, raising $51 billion a year, Johnson says.
  • Tax exotic financial instruments like derivatives at market value, for an extra $50 billion.
  • Tax estates at their full market values, disallowing  legal ploys meant to lower those values, which would be worth $25 billion.

Lillian Mills, McCombs accounting chair, targets a different deduction: home mortgage interest. It costs Uncle Sam $90 billion, according to the Joint Committee on Taxation. Mills would lower the upper limit on loan size from the current $1 million, so that McMansions would be taxed, but not middle-class homes.

She would also consider taxing the premiums employers pay for health insurance, netting the U.S. Treasury $148 billion. As a side benefit, she says, “It might make us all more price-sensitive to our health care.”

How to Cut Spending

Under a 2011 budget deal, defense and domestic discretionary spending are each to be reduced by $55 billion next year. The problem, says Leeds, is that the cuts are across the board, regardless of each program’s worth. “I don’t think it’s well thought out,” he says.

It’s also a thin sliver of a $1.1 trillion deficit. The big drivers of future deficits, says Mills, are the two biggest entitlement programs: Medicare and Social Security. The Treasury projects those programs to go $34 trillion in the red over the next 75 years. 

Mills would trim those deficits by gradually raising the eligibility ages for both programs, from the current 62 years for Social Security and 65 years for Medicare. “It has the benefit of shrinking entitlement payments,” she says. “Also, if people work longer, they pay taxes into the entitlement programs longer. It helps on both sides of the dial.”

What if There’s No Deal?

“I’m optimistic that Congress will solve the Fiscal Cliff,” says Mills. She expects a temporary extension of some tax cuts, with an agreement to reform the tax code early next year. Such a deal, she expects, “will help the global markets at least believe we’re not completely ignoring the problem.”

Leeds, on the other hand, would prefer to go partway over the cliff. If all tax cuts expired, by CBO projections, the deficit would be $550 billion smaller in 2020.

He hopes Taxmageddon might spark a national conversation. “If everyone is paying more taxes, we can have a real discussion,” he says. “Do we want to pay more taxes or do we want to cut some parts of the entitlement programs?”

The price might be a short-term recession, he acknowledges. He points to Budget Office forecasts that GDP would shrink 0.5 percent in 2013. But growth would resume in the second half of the year, and unemployment would drop to 5.5 percent over five years. And the CBO projects that ten years out, GDP would be 0.4 percent higher.

“At the end of the day,” says Leeds, “We don’t know what will happen to the economy under either scenario. The only thing that we know for certain is that our current path is unsustainable.”

Faculty in this Article

Calvin H. Johnson

Andrews & Kurth Centennial Professor School of Law, University of Texas at Austin

Calvin H. Johnson has been a member of the University of Texas Law School faculty since 1981. His research is currently focused around the...

Lillian Mills

Chair and Professor, Department of Accounting McCombs School of Business, The University of Texas at Austin

Lillian Mills received her BA from the the University of Florida in 1980 and her Ph.D. from the University of Michigan in 1996. Her research...

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

About The Author

Steve Brooks

Writer,

In a quarter-century as a journalist, Steve Brooks has won two Neal awards for excellence in trade reporting and a Press Club of New Orleans award...

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