Compromise Time? Eliminating the Fiscal Cliff With Current Tax Rates

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Congress has less than two months to prevent across-the-board tax increases scheduled to take effect  January 1, and the compromise legislation that could prevent these tax hikes is nowhere in sight. However, now that the election is behind us, it appears as if Congressional Republicans may be more inclined to compromise. Many members of the GOP have softened the strict position that they will not accept any tax increases for the upper classes, and Democrats may have begun to realize that they will be unable to raise the necessary revenue based on increases for the rich alone.

It is now time to prepare clients for an alternative plan—the fiscal cliff could be eliminated by maintaining current tax rates while capping deductions and reducing spending by reforming entitlement programs, such as Medicare and Social Security.

The Impending “Taxmageddon”

In approximately six weeks, taxes on nearly every form of taxable income will increase absent legislative action; these tax hikes will affect your clients in every tax bracket. Taxes on ordinary income will revert to pre-Bush-era levels, the tax rate on dividends will more than double, the maximum estate tax rate will rise from 35% to 55%, and taxes on certain capital gains will increase from 15% to 20%. Even the 2% payroll tax holiday is set to expire.

While most compromise legislation has focused on allowing some of these rates to rise while maintaining current rates for lower-income groups, Congress may be able to leave most tax rates in place if they focus on capping deductions and reducing spending for all taxpayers. Of course, while this is a tax increase in itself, the impact would be far less dramatic than allowing tax rates to increase across the board.

A Cap on Deductions

The Tax Policy Center recently released figures showing that a $17,000 cap on deductions (such as mortgage interest and charitable deductions) could raise an additional $1.7 trillion over the next 10 years. This far surpasses the $440 billion that would be raised during the subsequent 10 years by allowing tax rates for the wealthiest taxpayers to increase from 35% to 39.6%, as President Obama has proposed.

While this cap would impact some middle-class taxpayers, the Tax Policy Center found that the wealthiest taxpayers would generate the bulk of this additional revenue. Despite this, about 25% of the tax increase would affect taxpayers earning between $112,000 and $228,000—and 20% would impact taxpayers with incomes below the $112,000 level.

Despite this, it seems that capping deductions is an idea that both sides could be willing to work with. President Obama has proposed capping deductions at 28%, though this would raise only about $288 billion in the next ten years.

Reducing Entitlement Spending

Raising taxes is not the only way to prevent the impending fiscal cliff—reducing spending levels on entitlement programs, while extremely unpopular among liberals, could prevent outright tax increases in 2013. President Obama has previously indicated that he might be willing to increase Medicare premium levels and also increase the eligibility age from 65 to 67.

Similarly, proposals have been introduced that would increase the retirement age for Social Security purposes and limit annual cost-of-living increases for current recipients.

While these proposals are widely unpopular, some Republicans have said that any compromise would have to include a reduction in entitlement spending. Despite their unpopularity, the Republican position could force Congress to finally address some of the problems inherent in the entitlement system to guarantee more secure benefits for future generations.

Conclusion

Enough space exists between the Republicans’ proposed $17,000 cap and the president’s proposed 28% cap to make the possibility of finding a compromise position realistic. Reforming entitlement programs could help prevent an outright tax increase while increasing the longevity of these benefits. The emergence of these proposals post-election presents a potential silver lining to the impending fiscal cliff discussions and provides hope that a compromise can be reached.

For previous coverage of the potential 2013 tax increases, see "Retirement Planning for the Next Four Years Under President Obama."

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