The combination of increased taxes and spending reductions that will automatically take effect on January 1 if Congress does not act has the potential to decrease the budget deficit by around $600 billion next year but also tank the economy, according to estimates by the Congressional Budget Office.  Tax increases would account for about two-thirds of that, with increases in marginal tax rates and the expiration of the payroll tax reduction the biggest elements.

Here is a brief list of some of the changes that are slated to take effect in 2013 unless Democrats and Republicans can reach some compromise:

• The so-called Bush tax cuts will expire, resulting in a $200 billion hit to the economy.  The top ordinary income tax rate will increase to 39.6%, from 35%, and the long-term capital gains rate will climb to 20%, from 15%.  Dividends, now taxed at a 15% rate, will be taxed as ordinary income.  President Obama has proposed keeping the cuts for taxpayers with incomes under $250K, but the Republicans want the cuts retained for everyone.
• Unemployment benefits will drop back to 27 weeks from the current 99 weeks, representing an estimated $140 billion taken out of the economy.
• The alternative minimum tax, a separate tax system aimed at high-earners, will add about $94 billion in taxes to more than 4 million taxpayers unless Congress acts to pass special exemptions.  This is because the Tax Reform Act of 1969, the original law that targeted 155 tax-avoiding wealthy families, was not written to automatically adjust for inflation.  This is one area that is likely to be addressed before year-end.
• Because of the failure of the 2011 United States Congress Joint Select Committee on Deficit Reduction to reach a compromise on debt reduction, $85 billion in budget cuts – $50 billion in defense spending and a sizable bite out of payments to Medicare providers – are scheduled to take effect in January unless action is taken to avert them.
• The Budget Control Act of 2011 instituted caps on discretionary appropriations through 2021, excluding spending for the war in Afghanistan or designated emergencies.  Unless Congress overrides them, the spending caps would keep appropriations for 2012 and 2013 below the level of 2011 for an estimated $85 billion drag on the economy next year.
• The 2% Social Security payroll tax reduction introduced as part of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 is slated to expire.  Unless reinstated, a taxpayer earning $50K per year will end up paying about $80 per month more in taxes.
• The estate tax exemption is scheduled to drop from $5 million to $1 million.  According to published reports, the revised $1 million exemption level will impact approximately 53,000 estates for a total tax hit of more than $40 billion.
• Investment income will be subject to a 3.8% surtax for higher-income ($250K for married and $200K for single) taxpayers.   This is part of the funding model for the health care reform legislation passed in 2010.

What steps can you take to prepare for these changes?  From a tax standpoint, this may be the year to harvest capital gains.  Upper-income taxpayers could see the tax rate jump from 15% to 23.8%.  And if you own a corporation, you should additionally consider distributing the bulk of the retained earnings as dividends (since the dividend tax rate could jump from 15% to 39.6% next year).  A recessionary economy is also bad for stocks and lower-quality bonds, so lightening up on those asset classes in your portfolio might also make sense.

Perhaps the most valuable step you can take is to vote out of office those politicians that have been refusing to compromise!