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The Fiscal Cliff

by Ryan Law

With President Obama’s re-election a number of news articles are saying one of his first challenges is to deal with the upcoming “fiscal cliff”. Today’s article will attempt to explain what that means in simple terms and what it can mean in your life.

The “Fiscal Cliff” will begin on January 1, 2012 and means $7 trillion in tax increases and spending cuts over the next ten years. On the front-end that may not sound like a bad thing, but it could be crippling to the economy the way it is set up.

Spending Cuts

In 2011 the Budget Control Act was passed that increased the debt ceiling and called for a bipartisan debt-reduction deal or there would be automatic spending cuts. No deal was reached, so the following spending cuts begin in 2013:

  • Defense – $50 billion is cut from discretionary defense spending each year for the next ten years. Some military officials have said these cuts would be “devastating”[i]
  • Non-defense – a similar amount would be cut each year from non-defense spending. Some programs, like Medicaid, Social Security, civil and military employee pay and veterans benefits, are protected, but everything else, including education and air traffic safety, will be affected.

Tax Increases

The Bush Tax cuts would be eliminated, which means specifically:

  • Marginal tax rates will increase – they will go from current levels of 10, 15, 28, 33 and 35% to 15, 28, 31, 36 and 39.6%, respectively.
  • Capital gains rates will increase from 15% to 20%
  • Child tax credit will decrease from $1000 per child down to $500
  • The marriage penalty relief will expire
  • The estate tax exemption will go from $5 million to $1 million

In addition, the payroll tax holiday will expire, taking your payroll taxes from 4.2% to 6.2%, which means someone earning $30,000 will pay an extra $50 per month in payroll taxes

The Challenges

Experts have commented that there are two big challenges Congress and the President face:

  1. If all tax cuts stay where they are and no cuts are made in federal spending we will continue to face a mounting deficit of $1 trillion per year, which is unsustainable.
  2. If all the cuts go into effect the economy could be thrown back into a recession (cuts often mean job elimination or pay cuts and those with jobs will pay higher taxes).

Neither option is a good one – obviously Congress and the President need to work together to figure out the best path. Both parties have expressed that they plan to work together to come up with a solution.

While the country faces difficult economic challenges and has a long road ahead to get on solid financial ground, you can take steps to stabilize your own financial situation. As we always preach, learn to live on a budget, get out of debt and set up an emergency fund. These three steps can lead to financial peace of mind.

[i] http://www.defense.gov/news/newsarticle.aspx?id=118450