The Fiscal Cliff: What you need to know, in plain English

Before joining the College of Law, Professor José Gabilondo served in the Department of the Treasury’s Office of the Assistant General Counsel for Banking and Finance, where he advised the Bureau of Public Debt, the Social Security Trust funds, and other executive departments on a variety of legal matters.

We caught up with him to get his views on the fiscal matters that have been in the headlines.

FIU News: What is the “fiscal cliff?”

Gabilondo: This an alarmist metaphor that refers to a package of statutorily-required federal tax increases and spending cuts that kicks in Jan. 2of next year, unless Congress can come up with another fiscal plan. Ironically, this was the solution to a more serious problem: gridlock in Congress over raising the federal debt limit while curbing run-away spending. A divided Congress punted until after the election by agreeing tax increases and spending cuts that were never expected to see the light of day. So the package is remarkably fair because it spreads the fiscal burden broadly, balancing conservative and liberal values and putting in place some sound reforms. Congress didn’t mean to act responsibly, effectively, and in the public interest, but they did.

FIU News: What specific taxes and spending cuts are affected?

Gabilondo: Payroll taxes, income tax rates, the capital gains rate, and the estate tax will all go up. Unfortunately for those still out of work, the extension of unemployment benefits will also end. It’s harder to predict all of the spending cuts because federal agencies have some discretion when it comes to allocating the cuts. Funding for some state and local programs will be cut.  In general, the major social welfare programs – Social Security, Medicaid, food stamps, veterans’ benefits, Pell grants – are unaffected, although some Medicare reimbursement for doctors will be reduced.

FIU News: Who will be affected by tax increases?

Gabilondo: Almost everyone will be affected in some way. Anyone who earns wages as an employee (or hires employees) will have to pay more in payroll tax, which is a levy on an employee’s gross income that funds our Social Security program. Most controversial, though, are the increases on the marginal rates that individuals pay on their net income, i.e., income remaining after subtracting deductions and exemptions. Nearly all the marginal rates go up, but the effect would be progressive, and this is another virtue of going over the fiscal cliff. Since the tax reforms of the 1980s, the marginal rates on higher levels of income have climbed less steeply, becoming less progressive and looking more like the flat tax cherished by many conservatives.  The impending tax increases, however, return some rate progressivity to the tax code, raising rates higher on those with higher incomes, although still less than what they were even after the reduced rates we had after the 1980s reforms. Again – there’s no such thing as a welcome tax hike but these tax increases do spread the tax burden more fairly than would be the case if the usual lobbyists and Washington power brokers negotiated another tax deal.

FIU News: Why aren’t Congress and the current administration talking about enacting a progressive tax plan, which would increase tax rates as income increases? 

Gabilondo: It’s a sign of the times, though, that there is no serious discussion of restoring heftier marginal rates for the very rich. As Warren Buffett has made clear, someone earning $100 million a year can shoulder a higher marginal rate than someone earning $500,000 a year. During its first half-century, our federal income tax recognized as much: as late as the 1960s, the rates on the very rich reached 90%. See statistics. Beginning in the early 1980s, though, Reagan and Congress dropped it to 50%, delighting the wealthy but leaving a public debt that had tripled during his administration (suggesting that one is either a tax-and-spend Democrat or a borrow-and-spend Republican).  Since then, even Democrats (many of whom have also gotten wealthier) have been reluctant to call for our traditional marginal rates. The current tax burden on the very rich is the lightest in over a half-century, but, for many of the wealthiest, paying any tax will always be too much tax.

FIU News: Do all of the tax increases and spending cuts happen at once or are they incremental?

Gabilondo: Why I object to the ‘cliff’ metaphor is that it suggests a point of no return if 2012 ends without an alternative fiscal plan. In truth, though, Congress has all of 2013 to tinker with the tax law because the next (annual) tax year won’t end till December 2013, with returns due April 2014.  That said, employers are likely to begin increasing the amounts of payroll tax immediately in January, which will probably be the first contact most of us have with these fiscal policies.

The main effect of the budget cuts is to limit annual increases in spending. In recent years, defense spending has increased at a rate about 8% a year and social spending at about 6%.  The impending cuts will cap increases in future spending to about 1.5% a year, probably not enough to keep pace with inflation.  Entities that receive federal funds should have contingency plans for how to deal with reductions in federal funding.

FIU News: Have we been here before? And if so, how did we solve this before?

Gabilondo: Because until recently the two major parties tended to collaborate, we have forgotten that intense partisan opposition has been the norm during much of our history When I worked at the Treasury during the second Bush administration, we faced a debt limit crisis. Things were tense at times but clearly the executive and legislative departments were very familiar with how the game was played. The checks and balances system created by the Constitution works remarkably well, much like the rock-scissors-paper game that children play. The kind of extreme partisanship that we see today is nothing new, but our political system will muddle through. That said, in terms of our fiscal situation, we’re in new territory because our economy, our government, our annual deficits, and our outstanding public debt are larger than ever. Unfortunately, the domestic and international economies are weak, making it harder to imagine a plausible recovery.

FIU News: Assuming a deal is not reached before Jan. 1, do you see the potential for another recession or spike in unemployment?

Gabilondo: The fear is that these increases and spending cuts will slow down consumption, but put these concerns in context – especially the claim that $800 billion will be ‘taken out’ of the economy.  That statement is misleading because it does not reflect that value captured as taxes by the government stays in the economy because it gets recirculated by government spending. Moreover, these tax increases and spending cuts will dramatically reduce the amount that the government will have to borrow. The Congressional Budget Office (‘CBO’) has done some excellent forecasts of how these tax and spending changes might affect the economy. Assuming no alternative plan is found, the CBO predicts a short recession in the first half of 2013, followed by enough growth to end the year in an expansion.

This country’s problem with unemployment goes beyond our fiscal problems, unfortunately. The structure of our labor market has changed in ways that have not yet been adequately understood, let alone provisioned for by the government.