Part 2 will discuss the possible detrimental effects for taxpayers, business, investors, and the economy if legislation is not passed by December 31.

Many economists and others say if a compromise is not reached, the drastic reduction in government spending and tax rate increases will have very detrimental effects on the economy -heading into a recession-, charities and not-for-profit agencies, investors, and business.

A new 3.8 percent surtax on net investment income is going to go into effect January 2013.  [I have posted articles on the IRS proposed  regs  and  How to Plan for this New Tax]. There will likely be reductions of itemized deductions that could raise the tax rate on ordinary income to as high as an effective 44.6 percent for some taxpayers.  No one knows for sure how the tax law will be different in 2013.  It depends on what kind of compromise occurs between President Obama, the House and Senate. Speaker of the House, John Boehner (R, Ohio) and Senate Minority Leader Mitch McConnell (R, KY) have stated they will not stand for any tax increases. Republicans want revenue enhancement. This attempts to raise revenue by cutting loopholes and put limits on overall and specific deductions and credits.   President Obama, Senate Majority Leader Harry Reid (D, NV.), House Minority Leader Nancy Pelosi (D, CA.) have indicated they will not allow any tax cuts on wealthy taxpayers (defined by President Obama as taxpayers with income higher than $200,000 ($250,000 for married filing joint).  President Obama campaigned on raising taxes.  Many commentators, including this writer, believe that these income levels do not represent wealthy taxpayers.  This level of income is earned by many middle class taxpayers who are self-employed or operate their business as an S-Corporation. This is a small business corporation that is limited to 100 shareholders and the corporation does not pay in come tax. Shareholders report their share of the corporation’s income on their personal income tax return and pay self-employment tax on the income.

Some of the more popular and important tax provisions that will expire on December 31 unless Congress acts to extend them are:

(1) the 10% individual tax rate.

(2) the 15% maximum tax on long-term capital gains and dividends

(3) the increased standard deduction for married filing joint

(4) the exclusion from income of the discharge of debt on a principal residence

(5) certain advantageous student loan interest deductions.

(6) the American Opportunity tax credit for the first two years of college tuition

(7) Doctors who treat medicare patients face a 28% cut in payments

(8) the 2012 patch for the alternative minimum tax (AMT-an additional tax imposed on certain high income taxpayers- will expire and this tax will increase. The AMT is not indexed for inflation.  As a result, the IRS estimates that the number of taxpayers affected by the AMT will increase from 15 to 30 million and if a law is not passed before the end of the year it will have to reprogram its computers and refunds for those affected by the AMT will be delayed until mid March.

(9)  charitable gifts, up to $100,000, from your IRA (only allowed for those 70½ or older). This results in no income but a deduction is not allowed.

In addition to the above, the tax rate on long-term capital gains (securities held longer than one year) could increase from 15% to 20% and the rate on qualified dividends from15% to an effective rate of 44.6%.  Presently, for taxpayers whose tax bracket is higher than 15%,  long-term capital gains and qualified dividends are taxed at 15%. There is no tax for those in the 15% and lower bracket.  The social security tax on employers and self-employed will increase and the federal estate tax rate will increase from 35% to 55% and the exclusion amount will drop from $5,120,000 to $1,000,000.

Curtis Dubay of the Heritage Foundation, said taxes on 50% of households will increase and 710 million jobs will be lost, after tax wages, will decrease 1.8% and GDP will decrease 1.3% and the economy could go into a recession [appearance on The Willis Report, Fox Business  November 23, 2012].

Due to the uncertainty in business expansion, job growth is suffering…

Companies won’t invest as much of the $1.7-trillion hoard they’re sitting on until they see a clearer path on tax increases, the federal deficit and economic growth, plus the impact of health care changes. And if businesses don’t invest in new plants and equipment, new jobs won’t be generated in construction and manufacturing.  More mediocre job growth is likely through at least spring 2013 . . . longer if Washington continues to dither  [The Kiplinger Letter, “Forecasts For Management Decision Making”,  December 7, 2012].

TAX INCREASES

Several commentators recently spoke out on the tax increase on the wealthy that the president is insisting on . Neal Booritz, a commentator for Fox News appearing November 26 on Hannity said  “even if the tax increase on the wealthy that President Obama wants would raise enough revenue to fund the federal government for only 8.5 days.”  Martin Feldstein, Harvard economist and chief economic adviser to President Reagan, appearing on the same program said  “if we go over the fiscal cliff, the economy will definitely go into a recession, GDP will be reduced by 2%,and  if payroll tax cuts are ended, GDP will decrease 1%, and reduce household income. Raising revenue should be done by reducing tax expenditures, not raising taxes.”

President Obama and Treasury Secretary Timothy Geithner said they  “don’t see any alternative to raising taxes on the over $200,000 crowd-if the deficit is to be reduced without eviscerating government programs or raising taxes on the middle class” [David Wessel, “Stage Set For Next Act in Fiscal Drama”, The Wall Street Journal, November 15, 2012].

One commentator, James Baker III, Treasury Secretary under President George H. W. Bush, believes Congress should wait until 2013 to deal with the fiscal cliff. He said  “it is unrealistic to think that Congress could negotiate a far-reaching ‘grand bargain’ during its brief lame duck session this winter.  Lawmakers’ first order of business, then, should be to postpone all elements of the Jan. 1 fiscal cliff. . . for three months until March 31.  This would provide Washington enough time to negotiate a responsible compromise.” To accomplish this he says “would be to establish a mechanism guaranteeing that any agreed-upon spending cuts actually happen-and then remain in place after taxes are raised.  I propose an enforcement mechanism linking the revenue increases and spending cuts that make up the grand bargain. The parties would agree to cap federal spending at a certain percent of gross domestic product.  Were a future Congress to increase spending above that cap, then the tax increases would automatically be rescinded. Conversely, should future Congresses keep spending at or below the cap, then the tax increases would stay in place (unless a future Congress were to raise or lower taxes without increasing the debt).”  He also stated  “[a]ny effort to increase revenues should first focus on broadening the tax base rather than raising marginal tax rates” [“How to Get to a Grand Bargain”  The Wall Street Journal,  November 16, 2012].

CORPORATION TAXES

The U.S. has the highest marginal corporate tax rare in the world at a top rate of  35%.  Economist say corporations do not pay taxes–they are a cost of doing business and are passed on to customers in the form of higher prices or reduced dividends for shareholders. They are ultimately paid by the corporation’s owners-the shareholders and employees, with the corporation acting essentially as tax collectors.

Frederick W. Smith, CEO of Fed-Ex Corporation commented on the viability of a lower corporate tax rate.  He said:

To spur investment in the U.S., corporate taxes-now the highest among all major economies must be lowered to a competitive rate of 25%.  This rate would apply to all businesses large or small. I am for restoring American growth, employment and prosperity. This requires invention, innovation, entrepreneurship, and investment, which is highly correlated with job creation (which can only be achieved by a lower corporate tax rate) [letter to the editor, The Wall Street Journal. December 26, 2012].

Another business person also commented on how the high corporate tax rate hinders business growth.

The RATE Coalition is dedicated to seeing that comprehensive tax reform addresses the current corporate tax rate of 35%, which  leaves American businesses uncompetitive and hinders growth. This should be part of a larger, comprehensive and overdue tax reform that would take int account the concerns of small-business owners who pay under the individual tax code as well.  The debate has been unfolding and it is obvious that growth is constrained by an unnecessary burden, an inefficient and uncompetitive corporate tax rare. The top priority for Democrats and Republicans lawmakers is jobs. They know that reforming the corporate tax code and lowering the rate to an internationally competitive rate and broadening the base
is just the solution we need. Our lawmakers must lower the corporate tax rate, simplify the left is for our leaders to make the tough choices that our economy requires [Elaine Kamarck, Co-chair, “Reforming Americas Taxes Equity Coalition”, letter to the editor, The Wall Street Journal, December 26, 2012].

CHARITIES

If a compromise is not reached taxpayers are likely to reduce contributions to charitable and not-for-profit organizations. “It may sound attractive [cutting deductions] politically, but universities and nonprofit hospitals would shout that it would reduce rich folks incentive to give big bucks to charity.” [David Wessel , “Stage Set For Next Act in Fiscal  Drama”  The Wall Street Journal, November 15, 2012].

STOCK  MARKET

If the White House and lawmakers fail to reach an agreement to avoid the cliff, how will the financial markets react?  The Associated Press stated Congress and the White House cannot control, is the financial markets’ reaction, which possibly could be a panicky sell-off that triggers economic reversals worldwide.  The stock market’s unpredictability is perhaps the biggest wild card in the political showdown over the fiscal cliff. A chief fear for Obama’s supporters, however, is that Wall Street would be so disgusted or dismayed that stocks would plummet before lawmakers could prove their new-found willingness to mitigate the fiscal cliff’s harshest measures, including deep, across-the-board spending cuts that Defense Secretary Leon Panetta says could significantly damage the nation’s military posture. Some Republicans believe that fear will temper the president’s insistence on a hard bargain this month.

The inability to reach a compromise is having an effect on the stock market. A weak report on manufacturing activity increased concerns of business that the fiscal deadlock is already hurting the economy.  Ben Schwartz, chief market strategist at New York- based brokerage Lightspeed Financial said “if they [Democrats and Republicans]  put together a package in short order, . . . in the next couple weeks, you will see a strong rally.”  Stocks have fluctuated since the election because investors are concerned that a deal may not be reached in time to avoid tax hikes and spending cuts, which economists say could push the U.S. back into recession.  The S & P 500 is still 1.3% below its closing level on election day, having fallen as much as 5% since the election  [Associated Press, “Stocks Can’t Keep Early Gains”,  The Albany Times Union, December 4, 2012].

J.J. Kinahan, chief derivative strategist at TD Ameritrade, stated “Stock trading will likely become more volatile the longer talks progress without a deal.  Investors are waiting on developments from Washington in the budget talks, which are aimed at avoiding the sharp spending cuts and tax increases that begin to kick in January 1.”  [“Stocks calm amid D.C. talks”, The Wall Street Journal, December 5, 2012].

If the fiscal cliff occurs, this will hurt retailers profits and investors may no longer want to own retailers stocks. “But it also demonstrates how dependent they (retailers) are on the U.S. economy and, in particular, the course of discretionary consumer spending-exactly the area of the economy that will bear the brunt of the damage if the cliff isn’t avoided” [Justin Lahart, “Retail Hangs From The Cliff”,
The Wall Street Journal, December2. 2012].

On January 1, unless a compromise is reached, the rate on qualified dividends will increase from 15% to an effective rate of 44.6%.  As a result, many corporations are paying 2013 first quarter dividends in December.  Costco Wholesale recently moved to raise $3.5 billion in debt to pay a $3 billion, $7 a share, special dividend .  Several other companies have announced similar plans.  Dividends are normally paid from current and prior earnings without borrowing.

SMALL BUSINESS

Senator K. Bailey Hutchison (R, TX), appeared on the Fox Business program The Willis Factor December 23 said if taxes are raised this will wreck the economy and small business operations and employees will be harmed and will  hire fewer employees. They need predictability and stability. The president keeps proposing more taxes and spending. The latter plus the health care burden is why the economy and taxpayers have not and will not get better. Stop making it harder to create jobs, grow and expand by hiring people.

Mr. Boehner indicated that Obama Care and entitlements must be part of any compromise.  A provision in Obama Care mandates health care coverage for full time employees or penalties (to be administered by the IRS) will be imposed.  Many small businesses cannot afford this extra cost.  As a result, they will no longer hire full time workers and will reduce present workers hours to less than forty so they will not be considered full-time.

Many restaurants are cutting their profits forecast because of the uncertainty over the fiscal cliff compromise.  A Credit Suisse analyst said “restaurant-goers would ‘quickly lose their appetite’ if the U.S. went ‘over the cliff’ because the job cuts likely to follow would curb discretionary spending” [“Stocks calm amid D.C. talks”, The Wall Street Journal, December 5, 2012].

Another proposal to reduce the government deficit is to reduce extended federal unemployment benefits.  Unless the program is renewed ,benefits will expire at the end of the year. This could have detrimental effects. An editorial in The Washington Post said

It would be tragic if Congress abandoned the unemployment to clip a relative smidgen off the deficit-about $30 billion of a deficit of $1 trillion. . .  there were about seven applicants for every two openings. Americans who are either stuck in part-time jobs when they want full-time work or who’ve become so discouraged they’ve dropped out of the work force. By economist Mark Zandi’s projections, the failure to renew the programs will cost twice as much in lost economic growth due to the reduction in consumer spending.  It’s a mistake that’s both cruel and unaffordable, and Congress shouldn’t make. [reprinted in the Albany Times Union, November 22, 2012].

If the president and the Republicans reach a compromise and Congress passes legislation to avert the fiscal cliff and President Obama signs it, I will write another article discussing its major provisions and how they will affect taxpayers, the economy, investors, and business.

CIRCULAR 230 DISCLOSURE:  Pursuant to regulations governing practice before the IRS, any tax  advice contained herein is not intended or written to be used and cannot be used by the taxpayer  for the purpose of avoiding tax penalties that may be imposed on the taxpayer.