The recent election results combined with the impending “fiscal cliff” means that there will most likely be changes in tax rates in the near future.
For example, we are pretty much guaranteed that the federal estate and gift tax rules will change for the 12th time in the last 13 years. In fact, chances are very good that significantly more families will be directly impacted by these specific changes for the first time in the 21st Century.
To further understand the motivations behind these proposed changes, let’s first take a “Debt 101” approach in this post to describe the fiscal cliff we’re hearing so much about.
Purpose of Debt
Like any individual or business, governments earn money and spend money to help accomplish their goals. While individuals and businesses generally earn their money through the sales of goods and services, governments mainly earn their revenue through taxing the populace.
When an individual, business, or government spends more than it receives, it goes into debt. In other words, it must borrow money to pay off its existing obligations. While some might object to the notion of spending money that they don’t have, most of our world’s wealth has at least some basis on the borrowing of funds to help increase earnings over time.
- A good example at the individual level is the 30-year mortgage on a home. As most buyers cannot afford to pay full price for a house in their young adulthood, they instead choose to pay that price, plus interest, over 30 years’ time.
- Governments most commonly borrow money by issuing bonds. A bond is an agreement that is quite similar to a mortgage – one party lends $X to a second party (in this case, the government) and in return, the second party promises to pay back the $X, plus interest, to the first party over an agreed-upon period of time.
The U.S. Budget Deficit vs. the Federal Debt
Not surprisingly, the United States has a long history of debt. In fact, since the signing of the Constitution in 1789, the U.S. has held debt for all but one calendar year (1835) in its history.
Nowadays, the United States currently spends approximately $1 trillion more than it receives annually. For example, during the fiscal year ending in 2012, the U.S. spent $3.796 trillion while only earning $2.469 trillion in tax revenues (a $1.327 trillion budget deficit).
This “deficit spending” (i.e. the practice of spending more than receiving) is proposed to continue for at least another decade. The most recent budget proposal requests that the U.S. spend at least $575 billion more than it receives in every year through 2022. The U.S. will certainly be issuing a great number of bonds for the foreseeable future.
Over time, these budget deficits add up. The “debt held by the public” is the amount the federal government has borrowed from others to finance its accumulated cash deficits. As of November 16, 2012, the debt held by the public was about $11.45 trillion (see the U.S. Treasury’s TreasuryDirect site for the current amount of the public debt).
- To show its impact on our economy, the public debt is more commonly reported as a percentage of the gross domestic product (“GDP”). The GDP is a measure in dollars of what our economy produces (usually annually).
- As of November 16, 2012, the public debt is around 72% of GDP, which is way up from about 40% of GDP at the beginning of the Obama presidency in 2009. Naturally, during this year’s election campaign, Republicans blamed Democrats and Democrats blamed Republicans for the increase.
Regardless of who is at fault, most agree that the U.S. cannot sustain this level of increase much longer. In other words, the amounts the U.S. is paying in interest on its debts is starting to affect our ability to pay for other needs in the federal budget.
The Fiscal Cliff
Adding to all this fun is an immediate concern — tax cuts passed by the Bush administration in 2001 are set to expire this December 31. If they lapse without the government passing any law to replace it, taxes would revert to pre-2001 levels. We would all enjoy higher rates in all the income tax brackets.
At first glance, this would seem to create a significant increase in revenues for the U.S. government. Due to other existing laws on the books, federal spending is also set to decrease in 2013. The fiscal cliff refers to this combination of higher revenues and lower spending, which is projected to reduce our annual budget deficit by 43% in 2013 as compared to 2012.
While such a large reduction may sound appealing, the overriding fear is that this approach would likely lead us into a recession. The Congressional Budget Office reports that a reduction in government spending would reduce the GDP significantly and unemployment would increase.
- Why? Because if the government immediately stops buying as much, producers would lose revenue from one of its largest clients. As a result of this lost income, producers would then lay off employees to cut their own spending.
To summarize, simply letting the tax cuts expire at year-end creates too quick of a fix that would create a damaging fiscal cliff. There is no agreement yet on how to best accomplish a more gradual approach.
So What Does All Of This Have To Do With Estate Planning?
The frequent changes in estate and gift tax levels through the years reflect the frequent changes in political power and symbolize prevailing attitudes regarding taxation of the wealthy.
Part of President Obama’s winning platform involved deficit reduction partly through tax increases on the wealthiest Americans, so the estate and gift taxes are two obvious targets for implementing his plan. Some form of increase in these targets is likely coming very soon and could very well impact tens of thousands of families in 2013 alone.
Will your family be subject to estate or gift taxes? Check out Part II for a closer look at the proposed changes in the law and Part III to see how they could affect you and the fiscal cliff in general.