That was close!

 

How can the same piece of legislation be scored as both a $3.9 trillion tax cut and a $620 billion tax increase? It all depends upon your frame of reference.

            At about 2:00 a.m., January 1, 2013, the Senate passed the Taxpayer Relief Act of 2012 to avoid the “fiscal cliff” that had been set in motion in 2001 and renewed in 2010. Some 21 hours later, the House adopted the bill without amendment and sent it to the President. A cascade of tax increases thus was avoided. 

            Compared to the baseline of the 2012 tax law, the new legislation is projected to add $620 billion in tax revenue over the next ten years. But compared to the enormous tax increases that had been scheduled by prior Congresses, the new law is a tax cut.  Most of the “foregone revenue” is attributable to finally adding a permanent inflation adjustment to the Alternative Minimum Tax (AMT), eliminating the need for annual “patches.”  The irony is that Congress never intended to collect those taxes, but each year the “patch” would need to be offset by other tax increases.

            Key elements of the new law:

            • The 10%, 15%, 25%, 28% 33% and 35% tax brackets from the Bush tax cuts are made permanent.

            • A new 39.6% tax bracket applies to taxable income above $400,000 (singles), $425,000 (heads of households) and $450,000 (joint filers).

            • The phase-out of personal exemptions and the reduction in itemized deductions begin to apply at adjusted gross income of $250,000 (singles), $275,000 (heads of households) and $300,000 (joint filers).

            • For singles with income over $400,000 and marrieds filing jointly with more the $450,000, the capital gains tax rate and the qualified dividend tax rate go to 20%.  In addition, the 3.8% additional tax on investments under the Affordable Care Act will apply at this level of income, bringing the combined tax rate to 23.8%.

            The narrow difference in the thresholds between singles and marrieds is an implicit return to the “marriage penalty tax” for top earners. Two singles who each have $400,000 of income will not be affected by the 39.6% tax rate. Should they marry, $350,000 of their income will be taxed at that rate, an extra $16,100 in taxes.  In contrast, the new law preserves the provision of the Bush tax cuts that set the standard deduction for joint filers at double that for single filers.

 

Consequences

 

Higher tax rates mean that tax planning and tax-conscious investing will become more valuable that ever before.  Tax-free income from municipal bonds will become even more attractive.  The fact that the increase in dividend taxation is far less than it could have been should keep dividend-paying stocks attractive to many investors.

            The larger question is: Will the tax increase have an impact on the still-fragile economic recovery? That will be one of the major stories to follow in 2013.

(January 2013)

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