New Year’s Countdown to Higher U.S. Taxes Starts

Senate Majority Leader Harry Reid
Senate Majority Leader Harry Reid, a Democrat from Nevada, walks through the U.S. Capitol in Washington, D.C., U.S. Photographer: Andrew Harrer/Bloomberg

The expiration date has arrived.

A decade-long streak of reduced taxes on wages, capital gains, dividends and other income officially will end tomorrow if Congress doesn’t act.

The U.S. Congress hasn’t agreed on legislation to avoid any of the more than $600 billion in tax increases and spending cuts -- known as the fiscal cliff -- set to start taking effect in January.

Below are questions and answers about the status of budget negotiations and what happens next:

Where do the budget talks stand now?

Senate Majority Leader Harry Reid, a Nevada Democrat, and Republican Leader Mitch McConnell of Kentucky worked through the weekend on a bipartisan deal without reaching an agreement. Reid said last night that negotiations were continuing and that there may be announcements on the Senate floor at 11 a.m.

They are still divided over the estate tax, the income level at which higher income taxes would apply, the rates on capital gains and dividends, and how to prevent automatic spending cuts from starting.

Lawmakers emerged from their party caucuses yesterday to say that no deal had been reached yet.

House Speaker John Boehner, an Ohio Republican, called lawmakers back from holiday vacations to meet yesterday in Washington. It was the first Sunday session in the House since lawmakers convened in 2010 on health-care legislation. Boehner has said the House would look at whatever the Senate can produce and either pass it or change it.

What happens next?

President Barack Obama said Dec. 28 after a White House meeting with congressional leaders that if Republicans and Democrats couldn’t reach an agreement, there should be a vote on a scaled-back plan he outlined. It would raise taxes on annual income above $250,000 and extend expanded unemployment insurance benefits.

Senate Democrats say they will start setting up such a vote if they can’t reach an agreement with Republicans.

How did we get here?

The automatic cuts and tax increases were created by Congress and Obama through a confluence of events designed to put pressure on themselves to act on taxes, spending and the budget deficit.

In 2010, they extended the George W. Bush-era tax cuts for two years, which means breaks on income, capital gains, dividends and estates are scheduled to expire at the end of this year. Then in 2011 they set up $1.2 trillion in spending cuts to occur over nine years, starting in January 2013, as part of a deal to raise the U.S. debt ceiling. This year, lawmakers continued a two-percentage-point reduction in the payroll tax through Dec. 31.

Also, Congress hasn’t passed legislation that would keep millions more Americans from paying the alternative minimum tax this year and would extend other tax credits and deductions for 2012 tax returns as lawmakers have done in years past.

What about the debt ceiling?

The U.S. will reach the $16.4 trillion debt limit today, Treasury Secretary Timothy F. Geithner said Dec. 26. Geithner said he will take extraordinary measures to postpone a U.S. default and finance about $200 billion in deficit spending in 2013.

Typically, that would be enough for two months. Geithner didn’t set a specific deadline because of the lack of certainty about tax rates and spending.

Republicans have attempted to use the need for a debt-limit increase to force deeper spending cuts, replicating the 2011 showdown that caused the U.S. to come within days of default and led to a credit-rating downgrade.

So when will the debt limit be addressed?

Aides and lawmakers in both parties say they likely won’t address the debt limit in a year-end deal.

That decision sets up a fight over the next few months in which Republicans use the debt ceiling as leverage to force Obama to accept cuts in entitlement programs. Obama has said he won’t negotiate about the debt ceiling; he hasn’t explained what that means.

What happens if the U.S. goes “over the cliff”?

The Congressional Budget Office projects that the economy would go into recession in the first half of 2013 if the tax increases and spending cuts occur and aren’t retroactively resolved.

How have markets reacted to the lack of a deal so far?

U.S. stocks fell for a fifth day Dec. 28, the longest slump since September, as lawmakers approached the fiscal-cliff deadline without a compromise. The Standard & Poor’s 500 Index lost 1.1 percent to close at 1,402.43.

Benchmark U.S. 10-year Treasury yields capped their first weekly gain in a month as the cliff loomed. The securities lagged behind stocks this year by the most since 2009, with equities returning about eight times more than bonds.

How will that affect tax filing season?

If Congress doesn’t pass legislation to prevent expansion of the AMT, as many as 100 million U.S. households may not be able to file their tax returns until at least late March 2013, according to the Internal Revenue Service. That’s because the IRS programmed its computer systems assuming that Congress would eventually patch the AMT.

The tax filing season is scheduled to start in January and run through mid-April. A later start probably would delay refunds to taxpayers. Steven Miller, the acting IRS commissioner, has said there is no “magic time” when the agency would make a decision about delaying the filing season.

Congress also hasn’t extended dozens of tax breaks for 2012 returns that expired at the end of 2011, such as the ability to deduct sales taxes and teachers’ out-of-pocket expenses.

What do these negotiations mean for 2013 paychecks?

The IRS has said it will issue guidance by today on paycheck withholding for 2013, which depends on the income-tax rates Congress is debating. Higher rates would mean less take-home pay for workers starting as early as the first paycheck in January. Both Democrats and Republicans support extending current rates for families making less than $250,000. They disagree on whether to raise levies for top earners. Rates are scheduled to increase for all income levels Jan. 1 if Congress doesn’t act.

What about the payroll tax?

Workers also may see a reduction in paychecks starting in January if Congress lets the payroll tax cut of the past two years expire today as scheduled. That tax increase is more likely than the income tax increases because lawmakers in both parties have said they want to let it expire.

The payroll tax cut shaved 2 percentage points off of the 6.2 percent tax that pays for employees’ portion of Social Security. Workers making $50,000 and being paid twice a month will see their paychecks shrink by $41.67.

What has the Senate passed?

The Senate passed a bill in July that would extend the tax cuts for one year on income up to $200,000 for individuals and $250,000 for married couples. It also would extend tax credits from the 2009 stimulus law for low-income families and college students. It was silent on the estate tax because of disagreements among Democrats, and it didn’t address the automatic spending cuts.

That bill is also unconstitutional because it is a tax bill that started in the Senate, not the House.

What has the House passed?

The House, controlled by Republicans, passed a bill in August that would extend the expiring tax cuts for one year and begin a process for an overhaul of the U.S. tax code. It was silent on extending tax credits from the 2009 stimulus law for low-income families and college students. The House has passed bills that would delay automatic spending cuts -- known as sequestration -- by replacing them with other cuts.

What is sequestration and how does it work?

Sequestration is the official name for the automatic spending cuts, half of which would be in defense programs. The cuts are across-the-board, giving agency officials little discretion as to how to achieve them. Defense programs would face a 9.4 percent cut and most other agencies would be cut by 8.2 percent, the administration said earlier this year.

The cuts begin taking effect Jan. 2. Republicans want to find other spending reductions to replace them. Democrats are willing to use the higher taxes to delay the cuts.

Isn’t this Congress almost over?

Yes. The new Congress elected Nov. 6 starts its term on Jan. 3.

What does that mean?

That means the legislative process must start over and all bills proposed or awaiting action will die. Democrats will gain seats in the House and Senate. Republicans will still control the House and have procedural power to block action in the Senate.

Is it really a cliff or is it more of a slope?

A slope would be a better metaphor. Most of the effects -- the higher income tax rates and the spending cuts -- would occur gradually during 2013 and not deliver an immediate economic shock. For example, the Treasury Department has at least some authority to freeze paycheck withholding even if higher tax rates are in place.

Are there some changes that won’t depend on negotiations?

Yes. A 3.8 percent increase on income earned from investments, rents and so-called passive activities is set to take effect Jan. 1 as a result of the 2010 health-care law. That means U.S. income tax rates for top earners and investors will rise for the first time since 1993.

Republicans opposed the health-care law and wanted to repeal it if Obama didn’t win re-election. The law imposes a 0.9 percent additional tax increase on wages next year. Both surtaxes apply to individuals earning more than $200,000 a year or married couples earning more than $250,000. An excise tax on medical devices also will take effect.

-- With assistance from Inyoung Hwang in New York and Andrew Rummer in London. Editors: Jodi Schneider, Laurie Asseo

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