In Economy Lab on Wednesday, Mike Moffatt set out a strong case for serenity about the macro-economic impact of the upcoming 'fiscal cliff' in the United States. Unless action is taken soon, the fiscal cliff will occur on Jan. 1, 2013, when a large package of tax cuts is due to expire and a similarly large set of spending cuts will begin.
In brief, Prof. Moffatt argues that rational economic actors will not worry about temporary fiscal upheavals in the first few days of January if they believe a deal will eventually be found. People make decisions based on long-run expectations; short-term fluctuations are transitory and may be ignored.
However, before you put on your New Year's party hats and leave your fiscal worries behind, you should consider some serious tax policy spoilers that could arise as a result of the fiscal cliff. My UBC colleague Marit Rehavi, an expert on U.S. public finances, recently pointed out three examples to me.
First, capital gains and dividend taxes are set to rise if there is no deal by Jan. 1. This has two potential consequences. Looming higher rates can lead to stock market movements well before Jan. 1, as stock market players adjust in expectation of a change. For example, people may want to sell stocks with unrealized gains before Jan. 1 to lock in the lower rate. The other consequence is that accounting for whipsawing tax rates can quickly become complicated. In Canada in 2000, we had two capital gains inclusion rate changes, requiring a more complex tax form to sort out which transactions should be taxed at which rate.
As a second example of fiscal cliff tax difficulties, the Alternative Minimum Tax needs fixing. The AMT was last 'patched' in 2011, removing extra taxes from millions of U.S. taxpayers. As of yet, no 2012 patch has been enacted. Unless a new AMT patch is sewn into place before Jan. 1, the IRS Acting Commissioner has indicated that he must begin setting up the administrative systems with no patch --meaning that around 28 million taxpayers may be facing $92-billion of unexpected tax liability for the present 2012 tax year. In addition, millions more taxpayers would risk having their tax refunds delayed if the IRS is forced to change its systems, with the consequent loss of purchasing power of those taxpayers. Any deal reached after Jan. 1 would require time for the IRS to implement, meaning still more delays.
Third, the taxes that firms withhold from employee paycheques typically are governed by a withholding schedule set by the government in advance. The U.S. government has some leeway to tell firms to continue to use the 2012 withholding rates for the income tax, but for the Social Security and Medicare payroll tax, the tax is levied as a straight percentage of earnings so no withholding tables are used. This means that if a deal is not struck to extend the current payroll tax holiday, payroll taxes will rise with the first pay of 2013. This would have an immediate impact on take-home pay, and thus the economy as a whole.
Transitions between tax regimes take time and careful planning to get right. A scenario where the U.S. shifts quickly between lower and higher taxes – and then back to lower – may not have large long-term macroeconomic consequences. But the possibility of short term economic disruptions cannot be ignored.
Kevin Milligan is Associate Professor of Economics at the University of British Columbia