Falling off the Fiscal Cliff

The 2012 presidential election has come and gone in the U.S. The result was a resounding vote for the status quo. A divided government will continue; Barack Obama was re-elected; and the make-up of Congress essentially remains the same. The past four years have been mired in a global recession, which has shifted into a slow economic recovery marked by tepid recovery in the employment markets.

Facing a recession, the Obama administration during its first term embarked upon a program of massive government spending ostensibly aimed to ease the economic malaise. Consequently, during the past four years, the U.S. federal government has incurred significant budget deficits. This past election, Obama ran on a platform insistent upon increasing taxes, particularly on wealthy individuals. Obama’s tax and economic policy agenda has been met with stiff opposition in Congress, particularly among fiscal conservatives and the republican-controlled House of Representatives. The policy stand-off reached a crescendo when the White House and Congress failed to reach a long-term solution with respect to easing the increasing federal deficit. As a result, on Jan. 1, 2013, the U.S. faces the prospect of falling off the “fiscal cliff.”

The product produced by the policy-standoff was the enactment of a short-term federal budget which, absent congressional action, will result in mandatory spending cuts, the spring-back of higher federal income tax rates and the elimination of several other federal tax provisions. Jan. 1, 2013 has been characterized as the day the U.S. will fall off the “fiscal cliff” as a result of the expiration of tax-cuts, the imposition of mandatory spending cuts and the elimination of other favorable tax laws. Following the Nov. 6, 2012 U.S. election, neither Obama nor congressional leaders have demonstrated any willingness to reach a compromise on tax and spending. As the landscape now appears on the horizon of early December 2012, it appears that the U.S. is fast headed to tumbling over the fiscal cliff.

At the time of the writing of this article, the prospect of reaching an agreement on tax and fiscal policy before Dec. 31, 2012 appears bleak. The possibility exists that the White House and Congress can reach an agreement by early 2013. Regardless whether Congress and the White House can reach an agreement, changes to tax policy will occur on Jan. 1, 2013. As a result, the economic uncertainty of the past 4 years appears likely to continue well into 2013 and potentially beyond. Economic forecasts already predict modest economic growth in the short term. The impact of the impending tumbling over the fiscal cliff—or reaching a new agreement with respect to tax and fiscal policy—will impact the gaming industry. Thus, an examination of impending U.S. tax law changes and short-term economic forecast are in order.

Tax Law Changes for 2013 if No Fiscal Cliff Deal is Achieved
In the absence of new legislation, several provisions of prior tax law will spring into effect as of Jan. 1, 2013. The popular discussion has principally focused on the tax rate increases that will occur for individuals as result of the expiration of the Bush era tax rate cuts. The re-institution of higher tax rates is not the only significant consequence of falling off the fiscal cliff. Several other important law changes may occur, many of which are particularly relevant to the business and gaming community.

One significant change for the gaming industry is a change to the back-up withholding rate for gambling winnings. The withholding rate will increase to 28 percent. The withholding rate as of Dec. 31, 2012 was 25 percent. During the past several years, Congress has enacted tax law rules allowing for accelerated cost recovery with respect to several types of investments. These rules included allowing for a 50 percent bonus depreciation deduction for the purchases of certain qualifying property in the year the property is placed in service. The policy goal of allowing for accelerated cost recovery is to encourage investments by businesses. As of Dec. 31, 2012, many of the tax law provisions allowing for accelerated cost recovery will expire.

It should also be noted that a handful of business tax incentives expire as of Dec. 31, 2011. It is possible that some of these incentives may be reinstated in the event the White House and Congress can reach an agreement on the fiscal cliff. Incentives expiring on Dec. 31, 2011 include the research credit and a rule allowing for a 15-year amortization period for certain specialized realty assets, such as qualified leasehold improvements, qualified restaurant property and qualified retail improvement property. Reinstatement of the research credit may be particularly favorable to gaming technology companies to support the development of new products.

As previously noted, much of the focus of the fiscal cliff discussions has centered on the increase of individual tax rates. While individual rate increases may not directly affect the tax obligations of gaming businesses, rate increases may have a profound effect on business operations in two manners. First, employees of gaming businesses may face increased tax rates. Increased rates could affect the hiring and compensation decisions of businesses. Second, increased tax rates may place pressure on disposable income of consumers, which in turn could reduce the consumer spend on leisure activities. Hence, the bottom line for gaming operators could fall and correspondingly have a negative effect gaming operators purchases from gaming suppliers.

The potential rate increases reach individuals in at least three different manners. First, the nominal rates are scheduled to increase across most rate brackets. The highest marginal rates will increase from 35 percent to 39.6 percent. Second, personal exemptions will be phased-out for higher income individuals, as well as limiting itemized deductions. In turn, this will cause an increase in the effective rate by limiting deductions. Third, rate preferences for qualified dividend income and capital gains will be eliminated. In the context of dividends, this means that dividends paid to individuals will be taxed at ordinary income rates.

In addition to potential tax increases that could arise from a failure to reach an agreement on the fiscal cliff, individuals may face new taxes as a result of the implementation of the Affordable Care Act (ACA). Specifically, 2013 will usher in a new surtax on certain high-income individuals, which is imposed at 3.8 percent. The base of the surtax is the lesser of either “net investment income” or the portion of a taxpayer’s modified adjusted gross receipts that exceeds the threshold amounts. The threshold amounts are $250,000 for joint returns, $125,000 for married filing separately and $200,000 for all other taxpayers.

The ACA increases the hospital insurance (HI) tax rate for certain “high-income” individuals. An additional HI tax is imposed at a rate of 0.9 percent on taxpayers with wages above: (1) $250,000 and filing a joint return; (2) $125,000 if married filing separately; and (2) $200,000 for all others. For employers, the increased HI taxes will require greater compliance monitoring because of the introduction of graduated rates. In other words, employers will need to be prepared to closely monitor wages.

Even if Congress and the White House are able to reach an agreement on fiscal and tax policy, all or some of the above tax law changes may still go into effect. Thus, it is important to generally understand these tax law changes.

Fiscal Cliff and Economic Uncertainty
The real danger of the U.S. falling off the fiscal cliff is the economic impact. An August 2012 report prepared by the Congressional Budget Office (CBO) accentuates these economic dangers. If there is no agreement on the budget and taxes, and the U.S. does indeed fall off the fiscal cliff, the CBO predicts the economy in 2013 will mimic the period of 2008 through 2011. While the mandatory spending cuts will dramatically reduce the deficit, the “CBO expects that such fiscal tightening would lead to what will probably be deemed a recession, with growth in [the gross domestic product (GDP)] declining in 2013 and the unemployment rate staying above 8 percent through 2014.” The CBO attributes the prospective economic slowdown to “sharp increases in federal taxes and reductions in federal spending.”

After 2013, the CBO forecasts that the real GDP will begin to grow. However, the CBO report expects for 2014 to 2017 “the economy will continue to operate below its potential level … until 2018.”

The prognosis under an alternative scenario is not necessarily any more positive than maintaining the status quo. The CBO report also examined the effect of an alternative scenario whereby expiring tax law provisions are largely extended, the alternative minimum tax is indexed to inflation, Medicare’s payment rates to physicians remain unchanged and automatic spending reductions do not take effect. Under the alternative scenario, the CBO concluded that the short-term economy would be stronger. However, in the long-term, the economy would grow at a much slower pace. The CBO concluded that “[u]ltimately the policies assumed in the alternative fiscal scenario would lead to a level of federal debt that would be unsustainable from both a budgetary and an economic perspective.”

What does this mean for the gaming industry? Like many other businesses, the fiscal cliff and any potential resolution will have a significant economic impact. If Congress and the White House fail to reach an agreement and the U.S. actually falls off the fiscal cliff, tax rates will increase. The CBO projects that the corresponding effect of increased tax rates will push the U.S. economy back into a recession. As a result, disposable income is likely to fall and consuming spending on leisure activities—such as gaming—may decline as well. Even under alternative budget scenarios, the long-term economic prognosis is not any rosier. The current deficit level will continue to burden the economy and impact the ability to reach positive growth potential.

By the time this article is published, we will know with certainty whether the U.S. has fallen off the fiscal cliff. The current state of political affairs suggests that an agreement is unlikely, which will result in mandatory spending cuts and tax law changes becoming effective. Even if an agreement is reached, the posture of both the Obama administration and the republican-controlled House of Representatives make it likely that some of the tax rate increases and spending cuts will become effective. As outlined, the economic impact of the tax and fiscal policies will have a profound impact on the gaming industry. Under the best case scenario, the pragmatic economic forecasts suggest that economic growth will remain to be relatively modest. If the status quo remains, the economy is likely to fall into a deemed recession. As a result, the gaming industry may revisit the challenges it faced during 2008 through 2011.

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