Tumbling Off The Fiscal Cliff

So it seems that our Congress will not be able to come to any sort of agreement this year on how to handle the expiring tax provisions and budget issues that have been dubbed the Fiscal Cliff.  Is that a disaster?  No, not really.  They'll probably come to an agreement over the next few days (perhaps over drinks in a couple of hours), and this will all be but a happy memory.

However, in honor of our impending tumble off the Fiscal Cliff (cue the foreboding music), I thought I'd show you what this might mean for a couple of different American families, at least on the income tax side of things.  I'm not even going to pretend to know what it would mean on the budget side.

Oh, and in case you didn't realize this, I am not giving any tax advice in this blog entry (or in any of my blog entries), so don't you dare do something stupid with your money and then blame me.  Moving on...

I've invented two lovely families to use as examples of what the Fiscal Cliff would do to a couple of different tax situations.  For the purposes of my scenarios, no one ever gets raises or changes their spending habits or even pays down debt. Unfortunately, this is not far from reality.

First, let's look at Henry and Margaret Doe.  They are what most people would consider "middle class."  They live in a nice house in the city with their two lovely children.  Henry makes about $75,000 a year, and his loving wife makes about $30,000.  They put 10% of their income into their 401(k)s.  They only make about $20 of interest per year, though, because they don't actually have a lot of money.  They have a fairly hefty amount of debt, so much that their mortgage interest deduction is about $10,000 a year, and a chunk of that is actually home equity debt from when they refinanced some of their credit cards.

In 2011, they had a federal tax liability of close to $7,000 at a marginal rate of 15%.

In 2012, because Congress hasn't "patched" the Alternative Minimum Tax yet, they are going to pay about $7,800 at a 26% marginal rate.

AMT, you ask?  But Henry and Margaret aren't rich.  They are barely making their house payments and are underwater on their mortgage.  I thought the AMT was designed to keep rich people from dodging taxes!

Well, whether Henry and Margaret are rich or not is relative.  They're richer than the vast majority of people in the world, and they're richer than most Americans, too.  The AMT is expected to affect a huge chunk of American taxpayers if it isn't patched because it doesn't allow you to deduct things like home equity interest or state income taxes.  Oh, and did I mention that Henry and Margaret live in Oregon?  They pay a lot of state income taxes.

2013 is going to get even uglier for Henry and Margaret.  In fact, they won't even be subject to the AMT because their regular tax will have skyrocketed.  The 10% tax bracket is disappearing and the tax brackets for married taxpayers are shrinking.  Tax rates are going up, too, and Henry and Margaret will basically lose the $2,000 child tax credit they've been enjoying for Henry Jr and Little Maggie.  If the laws are left unchanged, their 2013 federal tax bill will be close to $10,000.  Ouch!

Now let's look at a different American taxpayer. Jake and Ally Donaldson are in their upper 20s.  Like Henry and Margaret, they are college-educated and have two darling children.  Unfortunately, Jake is only making $50,000 a year, and Ally is home taking care of the kids.

Jake and Ally are basically living at the American median income.  They aren't even pretending to be rich.  Those degrees were expensive, though, and Jake and Allie are deducting the full $2,500 of student loan interest on their tax returns along with getting the $2,000 child tax credit.

In 2011, Jake and Ally paid only $300 in federal income tax, and in 2012 they will pay less than $200 because of the increasing exemptions.

2013 is a different story, however.  Jake and Ally are slated to lose their student loan interest deduction.  In addition, the child tax credit will be only half what it was in 2012.  Consequently, if the law stands as it is, Jake and Ally will pay more the $2,600 in federal tax for 2013.  That's a big jump!

Keep in mind that Congress will probably extend the Bush tax cuts for both of these families, and they can continue to live at the level to which they have become accustomed.

I thought this would be an interesting way to look at the effects of tax laws.  You can take this information and come to whatever conclusions you want.  Note a couple of things, however:

• The Donaldson tax bill is going to go up nearly as much as the Doe tax bill is in actual dollars, but while the Doe tax bill is increasing by almost 40%, the Donaldson tax bill is increasing by well over 700%.
• Jake and Ally make about half what Henry and Margaret make, but have a lot less than half of their tax bill.
• Both of these families pay a lot of social security taxes, too.

Oh, and let's not forget that as of the moment I'm writing this the national debt stands at over $16 trillion.  That's more than $52,000 per American citizen, and we currently have a $1 trillion per year deficit, so that's only going to get bigger.

What do you think?  Should the taxes on these families increase?  What can we do to reduce spending if we don't want taxes to go up?

If you haven't seen this yet, I recommend visiting the Wall Street Journal's Make Your Own Deficit-Reduction Plan.  It allows you to try your hand at reducing the deficit yourself.  Make lots of cuts.  Raise taxes on everyone you don't like (or maybe on yourself).  You'll see how big this problem really is.

I wish all of you a very Happy New Year, and please don't hurt yourself falling off the fiscal cliff.