Congress is playing a game of high stakes chicken with the extension of the Bush tax cuts, leading to tax uncertainty in 2013. Earlier this month, the Senate defeated both President Obama”s proposal to extend cuts for everyone making under $200,000 and the Republican proposal to extend all of the current rates. Congressional Democrats meanwhile are seeking to extend the rates for everyone making less than a million dollars a year. All three sides are refusing to budge as the President has promised to veto any cut extensions for individuals making over $200,000 or families making more than $250,000.
On Monday, Senator Patty Murray (D-WA) stated that if the three sides could not come to an agreement, Senate Democrats were prepared to let all the Bush tax cuts expire. The result would be an increase in every tax bracket and increases in taxes on investments at all income levels. Fortunately, this is likely an empty threat.
What this does mean is that we may have another situation like 2010 where the tax rates for 2013 won”t be known until the last week of December. In fact, we may not know until the first quarter of 2013 when the winners of the 2012 congressional and Presidential elections come together and retroactively fix whatever does not get done before the end of the year.
What would US tax rates look like if no agreement can be reached? For the lowest tax bracket it would be a 10% tax increase on capital gains, 15% on dividends and 5% on income. For the top bracket it would be a 5% increase on capital gains, 19.6% increase on dividends and 4.6% on income. People in the lower tax brackets may not have much investment income, unless they are retirees. However, the 5% increase in income tax will affect these filers in ways that politicians up for re-election don”t want.
Why $200,000 and $250,000?
These seem to be the magic numbers when it comes to taxing the wealthy. In the Affordable Care Act, there is a 3.8% tax increase on unearned income for people who reach the $200,000 mark ($250,000 for families) and a .9% increase on earned income. When combined with the expiration of the current rates for people making theses amounts, the result is an 8.8% increase on capital gains, 23.4% increase on dividends and 5.5% increase on income.
What is significant about these two thresholds is the marriage penalty. If a husband makes $75,000 and his wife makes $175,000, they will trigger these higher tax rates. But if they are not married, they will enjoy the lower tax brackets. In fact, as an unmarried couple they could increase their combined income by another $150,000 before they started paying at the higher rates.
If no deal can be reached on the expiring Bush tax rates, the marriage penalty reduction built into the Bush tax cuts will also be eliminated and the tax consequences will hit more than just those making $250,000 or more.
Other Expiring Provisions
In the DC staring contest, current tax rates aren”t the only thing that will expire if the government does nothing. Here are some other expiring provisions:
- The Child Tax Credit will drop from $1,000 to $500
- The American Opportunity Tax Credit for students in their first four years of college will expire
- The reduction in the marriage penalty through the way the tax brackets are set up will expire
- The AMT patch is set to expire
- The Estate Tax will return to 55% with a $1 million exclusion
- The 2% reduction in Social Security tax withholding is set to expire
- The Adoption credit will drop to $5,000-$6,000 and become non-refundable
The expiration of these provisions, dubbed by some as part of the “fiscal cliff”, would reach every family in America. We therefore join with most experts in believing that a deal will be reached either by the end of this year or early next year.