Fiscal Cliff Averted: Tax Picture Is Now Clear

Congress and the White House reached a deal yesterday to avert the so-called fiscal cliff, the combination of automatic tax increases and spending cuts that likely would have pushed the economy back into recession.

From a tax perspective, the deal is good news because it provides certainty. We now know what to expect for taxes in 2013. Few households with incomes of less than $500,000 will face an income tax increase. In fact, less than 5 percent of households earning between $200,000 and $500,000 will pay more, according to the Tax Policy Center. But nearly everyone will pay more payroll tax, as the 2 percent payroll tax reduction was allowed to expire.

Among the important provisions of the bill:

• The Bush-era tax cuts will expire for households earning more than $450,000. The top income tax rate will rise to 39.5 percent from 35 percent. But the higher rate will apply only to income above $450,000. All income below $450,000 still will be taxed at the lower 35 percent rate.
• The tax rate on capital gains and dividend income was set at 20 percent for households making more than $450,000 and at 15 percent for those below that level.
• The alternative minimum tax exemption was extended, protecting 30 million Americans who would have been hit by the levy this year. 
• The payroll tax will go up by 2 percentage points, reverting to 6.2 percent from 4.2 percent on all earned income up to $113,700. This means most households will pay higher payroll taxes because the deal did not extend this two-year-old tax break. A household earning $100,000, for example, will pay $2,000 more in payroll tax.
• The estate tax rate was set at 40 percent with a $5 million individual exemption. That's far better than the 55 percent rate and $1 million exemption that would have gone into effect if the Bush tax cuts had expired as scheduled.

While the deal provides certainty on taxes, it did nothing to address serious federal budget issues.

First, Congress did not tackle the debt ceiling. The federal government will bump up against the debt ceiling by March. Raising the debt ceiling requires congressional approval.

Second, Congress did not make tough decisions regarding budget cuts and long-term deficit reduction. It merely pushed off these decisions until March. If no agreement is reached by then, automatic spending cuts will go into effect - bringing us right back to the fiscal cliff. So we can expect another political showdown when Congress takes up these issues in March.