Taxes and Spending

I suspect I'm wading into deep water here, but bear with me.

The so-called "fiscal cliff" is in the news a great deal these days - any more coverage and one might think that the story was nearly as important as shirtless FBI agents and phone sex with a general! Starting in January 2013, a variety of taxes will go up and other taxes will take effect.

A great many taxes, tax credits, and the like are scheduled to be affected. Some changes mainly affect upper-middle-class and upper-class households, such as:

• Exemption phase-out
• Itemized deduction phase-out
• Capital gains tax rate increasing from 15 to 20%
• AMT fix expiring

Others affect everyone paying income or payroll taxes:

• Payroll tax returning to 6.2% from 4.2%
• Increase in marginal tax rates:
• 10% rate disappears;
• the 25%, 28%, and 33% rates increase by 3 percentage points
• the 35% rate increases to 39.6%

Still other changes affect mainly lower-income households:

• Various other tax credits being reduced, including
• Child Tax Credit
• Child & Dependent Care Credit
• Earned Income Tax Credit

• Higher interest rates on educational loans
• Lower limits on flexible health care spending accounts, higher threshold for itemizing medical expenses

Still other changes affect businesses directly, but will affect consumers indirectly (e.g., the reduction in Medicare reimbursement rates to doctors).

(The above tax changes are separate from the simultaneous imposition of a variety of taxes and fees from Obamacare - for example, a surtax on medical equipment, and the obligation of firms with a large enough number of employees and full-time employees to provide health care coverage or face a fine. Because I don't need a reminder about how much folks outside the U.S. love their national health systems, I will ignore these taxes and fees in this discussion.)

Furthermore, the effects of the sequestration bill are scheduled to go into effect, which will result in cuts in Federal spending. Although the specific effects vary by department or agency, it's roughly a 10% cut in discretionary domestic and defense spending (i.e., not Social Security, Medicare, Medicaid, or other entitlement spending). The direct consequences will be that some government employees will lose their jobs. Indirect consequences include the concomitant reduction in spending by those newly unemployed workers and a reduction in government services, including national defense.

Both political parties seemingly want to avoid the most disastrous outcome, and both parties have made proposals to address some of the laundry list of changes outlined above. Most famously, President Obama has taken the position that the 2001 tax rates stay the same for individuals making less than $200,000 per year (or households making less than $250,000), while the House has proposed extending rates to all taxpayers. Like most pundits and wannabe pundits, I expect Congress to arrive at a last-minute deal that satisfies no one and continues to kick the problem down the road.
In the second part, I'll argue that current deficit levels are not sustainable, particularly when one considers that the situation will become worse once interest rates rise and the population continues to age.