What the 'Fiscal Cliff' Will Mean for You

Fiscal Cliff
Fiscal Cliff

The economy is rumbling along, out of control, with nobody at the reins. Straight ahead, the road abruptly ends, yet the horses show no signs of slowing. Next stop: the fiscal cliff!

Much like a scene out of an Indiana Jones movie, the wild ride to Jan. 1, 2013 is developing into a perfect storm of economic and political pusillanimity. And in a sense, it's been headed this way since the first reel: Facing a financial crisis that threatened to sink America's credit rating, Congress agreed to increase the debt ceiling, but only if the conservatives were given a major deal to reduce the deficit.

But those same legislators were unable to agree on what combination of tax increases and budget cuts would be employed to shrink the deficit, so they punted that problem to a "super committee" of 12 congressmen and senators who were tasked with untangling the Gordian knot of America's finances. That super committee was given the best incentive a congressman could imagine to craft a compromise: Failure meant automatic cuts to federal spending across the board, painful to both Democrats and Republicans alike.

It wasn't enough of a goad: The super committee also failed, triggering those billions in automatic cuts, which will kick in on New Year's Day.

But that's not all. In addition to the federal spending cuts, the Bush tax cuts that have been in effect since the early 2000s are also set to expire on the same day, automatically raising tax rates. So unless Congress acts, the federal government will start charging its citizens far more in an array of taxes and offering fewer services in exchange.

This, is the much-talked-of fiscal cliff. And for the average American family, it could be a pretty rough fall.

Getty Images
Getty Images

How the Fiscal Cliff Will Affect You

To get an idea of how the fiscal cliff will affect the average American family, it helps to understand exactly what that family looks like. According to the Census Bureau, the median American household has 2.6 people and brings home just under $50,000. With the expiration of the Bush tax cuts, the first thing that will hit this family is an immediate, steep increase in the amount that it sends to the IRS.

After the standard deduction, the average family currently pays 10% of its income up to $17,400 and 15% of all income between $17,401 and $70,700. For a family making $50,000, this works out to $4,845 in base taxes. If we revert to pre-Bush rates in 2013, the average family will pay 15% taxes on all its income. For a middle class family, this works out to a tax bill of $6,397, a jump of $1,552.

[An earlier version of this story used back-of-the-envelope calculations to estimate an even higher tax jump. This version more accurately reflects the tax brackets and standard deductions of the pre-Bush tax code.]

Of course, nobody pays the full tax rate; every family gets deductions that decrease its tax burden. Unfortunately, many of these deductions will vanish on Jan. 1, too. For example, the child tax credit, which gave this average family a $1,000 tax deduction this year, will be cut in half, increasing their tax burden by $500.

If our hypothetical family has a child in college, it will feel the pinch even more. Currently, families that make $100,000 or less can claim the American Opportunity Tax Credit, which allows them to deduct up to $2,500 in school expenditures for every student for up to four years. On Jan. 1, that benefit expires, and the less-generous Hope credit is all that's left to take its place. Under Hope, families making less than $100,000 can claim $1,800 per child for up to two years.

In other words, a middle class family with a child in college can expect to get $700 less in deductions immediately, and $6,400 less in deductions over the course of their child's education.

It gets worse: the "payroll tax holiday," a 2% Social Security tax cut on the first $110,000 in wages, is set to end. For the average family, this will mean a tax hike of $1,000 per year. At the same time, the average middle class family will also get hit with the expiration of the "marriage penalty reduction," a break that was included in the Bush tax cuts. Basically, this cut enabled low- to middle-income couples filing together to pay less in taxes than they'd pay if they filed separately. With its expiration, couples will face an increase in taxes if they choose to file jointly.

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Moving Beyond the Average

Of course, average families aren't the only ones who will be affected by the fiscal cliff. For lower income households, the loss of the Earned Income Tax Credit will hit hard. This credit encourages poor families to work by partially offsetting their Social Security expenditures. Childless couples making $19,190 or less receive $475 per year, and benefits increase depending on the number of children a family has and the amount of money that it makes. For example, families with three children can receive up to $5,891, even if they make up to $50,270 per year. When all those other sweeping changes hit in 2013, the EIC will be scaled back.

In all likelihood, the average middle class family won't be affected by changes in the estate tax. Currently, survivors have an exemption of up to $5 million on inheritance, and pay 35% on any money above that level. On Jan. 1, the exemption will drop to $1 million and the tax rate will increase to 55%.

At the same time, the capital gains and dividend tax rates will also increase. The capital gains rate, currently 15%, will go up to 20%, while the 15% dividend tax rate will rise to match the income tax rate. These changes will be unpleasant for people who derive most of their income from investments, but will likely not significantly affect the average wage-earning household.

Sweeping Changes

Beyond the direct effects of the tax hikes, Jan. 1 will bring sweeping changes that will affect most of the country. For example, the Defense Department will see its budget cut by 10% across the board, a slash that will likely result in the shuttering or scaling back of hundreds of programs. And that will ripple through the economy in terms of job cuts, fewer workers spending less money, and in turn paying less into the system in taxes.

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What's more, when those defense workers lose their jobs, they'll have to scramble for new work. Currently, unemployment benefits last for 99 weeks, but on Jan. 1, the limit will revert to 26 weeks. And that means an already-tight job market is about to get rougher as it is flooded with thousands of new unemployed at the same time that the currently jobless become a lot more desperate.

And there's more bad news: every "discretionary" program -- effectively, every program that doesn't have earmarked funds, will face an 8% cut. Schools, roads, public health, food inspections, homeland security, and almost every other federally-funded program will be scaling back services.

Even some entitlement programs are set to get hit. Medicare rates, for example, will drop by 2%, making it harder for providers to offer the same level of service, and setting the stage for a drop in the number of providers.

'Fasten Your Seat Belts. It's Going to Be a Bumpy Night.'

Given the broadly sweeping effects of the fiscal cliff, it's not surprising that the looming disaster has earned other names, like "Taxmaggedon" and "Taxpocalypse." The expiring tax cuts will hit every worker, and the reduced federal expenditures will ripple across the economy. According to the economic gurus, letting this happen will likely send the country back into recession.

Meanwhile, both parties in Congress are faced off against each other, with neither side willing to budge. Republicans refuse to allow the Bush tax cuts for the wealthy to expire, and Democrats refuse to allow budget cuts to fall inequitably on the heads of the poor. Both groups are hoping to pick up House and Senate seats in November, after which they expect to enact an eleventh-hour solution that will rein in the horses, turn the stagecoach aside, and keep the economy from plunging off the cliff. Both sides are planning to be in the driver's seat when that occurs.

But will that happen? Wall Street, at least, seems to think a last-minute save is unlikely. As The New York Times reported on Monday, manufacturers across the country have decided to delay orders, hold off on capital improvements, and postpone hiring, largely out of a belief that the federal government won't be able to get its act together. What's more, as frightened manufacturers delay investment, the rate of economic growth is slowing, from 4.1% at the end of last year to an anemic 1.5%. In other words, while Congress is waiting for the fiscal cliff to arrive, it may already be here.

CFOs Peer Over the U.S. Fiscal Cliff
CFOs Peer Over the U.S. Fiscal Cliff

Bruce Watson is a senior features writer for DailyFinance. You can reach him by e-mail at bruce.watson@teamaol.com, or follow him on Twitter at @bruce1971.

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