Looming Tax Increases Could Prompt Recession Next Year

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The Congressional Budget Office has issued a report warning that the economy could slip into a recession unless policymakers decide what to do about the steep tax increases and spending cuts that are scheduled to take effect next year.

The report, issued Tuesday, predicted that gross domestic product would grow just 0.5 percent next year and the economy would contract at an annual rate of 1.3 percent in the first half of the year, before expanding at an annual rate of 2.3 percent in the second half of the year. “Given the pattern of past recessions as identified by the National Bureau of Economic Research, such a contraction in output in the first half of 2013 would probably be judged to be a recession,” said the report.

Among the many items on the agenda in Washington are the expiration of the Bush-era tax rates at the end of 2012, which were extended for just two years at the end of 2010. Currently Democrats and Republicans remain at odds over the extension of those tax cuts, with the Obama administration wanting to extend them only for those earning under $250,000 a year, while Republican lawmakers insist they should be extended for higher-income taxpayers as well. As a silver lining, if the tax cuts are not extended, the CBO estimates that would reduce the federal budget deficit by $221 billion between fiscal years 2012 and 2013.

The annual “patch” that traditionally prevents the alternative minimum tax from spreading to millions more taxpayers has yet to be passed for either this year or next year. That would add a double whammy to the pocketbooks of middle-class taxpayers.

The 2-percentage-point payroll tax cut is also slated to expire at the end of the year. If it went away, that would raise revenues for the federal government by $95 billion. On the other hand, the Obama administration estimates that it put an extra $40 in the pockets of the average taxpayer for every two-week paycheck, helping boost consumer spending.

Other items that are slated to expire at the end of the year, or that already expired at the end of last year and have yet to be renewed, include the dozens of so-called “tax extenders.” The largest that is slated to expire at the end of this year, according to the CBO, is the tax break for partial expensing of investment property.

Some provisions of the Affordable Care Act, including increased tax rates on earnings and investment income for high-income taxpayers, are scheduled to take effect in January. On top of that, deficit reduction provisions of last year’s Budget Control Act created automatic enforcement procedures designed to force lawmakers to agree on a set of spending cuts and revenue raisers. Otherwise steep cuts in defense programs and discretionary spending would automatically be triggered and go into effect. While that would lower outlays by $65 billion in fiscal 2013 and another $41 billion in subsequent years, it would also mean slashing benefits in many social programs on top of cuts to the military.

Emergency unemployment benefits are also scheduled to run out at the end of 2012. In addition, the so-called “doc fix” to prevent Medicare reimbursement rates to physicians from plunging is set to expire at the end of this year.

All the extra tax revenues and spending cuts from these changes might be good news to budget hawks. There would be a gross reduction in the deficit of $607 billion, or a net reduction of $560 billion, between fiscal years 2012 and 2013. But the dramatic spending cuts and tax increases might also have a devastating effect on many individuals and broad sectors of the economy.

“The weakening of the economy that will result from that fiscal restraint will lower taxable incomes and, therefore, revenues, and it will increase spending in some categories—for unemployment insurance, for instance,” said the CBO report. “Those automatic responses will raise the federal deficit by $47 billion, in CBO’s estimation, leaving a net projected reduction in the deficit between fiscal years 2012 and 2013 of $560 billion. As a result, the budget deficit will decline by 3.7 percent of GDP between those two fiscal years, according to CBO’s estimates.”

Another worry is the raising of the debt limit early next year. Speaker of the House John Boehner, R-Ohio, has indicated that he again wants more spending cuts before agreeing to raise the debt limit. The last time around, the fight between Democrats and Republicans in Congress prompted Standard & Poor’s to lower its credit rating for the U.S.

The CBO report could finally induce Democratic and Republican lawmakers in Washington to return to the bargaining table to prevent the economy from going over the side of the so-called “fiscal cliff.” Recently there have been some calls in Congress for lawmakers to start negotiating. Last week, a group of 41 Republican senators, led by Sen. Orrin Hatch, R-Utah, the ranking Republican member on the Senate Finance Committee, wrote a letter to Senate Majority Leader Harry Reid, D-Nev., calling on him to extend the expiring tax provisions before the end of the year. They warned that unless all the tax cuts were extended, it would lead to $310 billion in tax increases next year.

“The adverse impact of these tax increases on economic growth is unquestioned,” Hatch and his colleagues wrote.  “It is our understanding that last week Federal Reserve Chairman Ben Bernanke reconfirmed in a discussion with Senate Democrats that the nation faces a ‘fiscal cliff’ so significant that the Chairman said that monetary policy would not be capable of offsetting the resulting decline in economic growth.  And the former Director of President Obama’s Office of Management and Budget concluded that what he estimates to be a $500 billion tax increase would be so large that 'the economy could be thrown back into a recession.' The impact of this fiscal cliff might actually be understated. Billions in new taxes on capital that were enacted as part of the President’s health care law come online in 2013, and they will almost certainly dampen economic growth even further.”

Reid, however, responded in a letter Monday that Republicans need to “abandon their commitment to more tax breaks for multimillionaires and special interests and their plans to end Medicare,” adding, “Republicans’ blind adherence to Tea Party extremism is making it impossible to reach this sort of balanced agreement before the election.”

The problem is that with so much important business being pushed into the so-called “lame duck session” after the election, observers are warning of a chaotic time in Congress at the end of the year. The CBO report provides a reminder that unless Congress begins working on the framework of a deal before the election, the economy could be seriously harmed next year. The November election will likely determine the final shape of that deal, but even in the current highly charged political environment, lawmakers have a responsibility to at least begin laying the groundwork and reduce uncertainty about the economy and taxes next year.

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