Fiscal Standoff?

With two weeks left before the end of the year, Congress and President Obama still appear far apart on a possible agreement to avert a pending "fiscal cliff" of tax increases and across-the-board spending cuts that will begin to phase in starting in January if no agreement is reached.

Despite the hype, the sky will not fall if no agreement is reached by Jan. 1. The administration has significant authority to delay the effects of both the spending cuts and tax increases for several weeks if necessary. The real fiscal cliff is not likely to be reached until February or March, when federal borrowing reaches the statutorily set debt ceiling.

The primary source of disagreement between the two sides is whether to extend Bush-era tax cuts for upper-income individuals. President Obama campaigned on letting the tax cuts expire for individuals making more than $200,000 per year and couples making more than $250,000 per year. On Dec. 14, House Speaker John Boehner (R-OH) countered with an offer to allow income tax rates to rise on those making more than $1 million per year. On Dec. 17, President Obama countered with an offer to allow income tax rates to rise on those making more than $400,000.

Some Democrats, including Sen. Patty Murray (D-WA), believe that Democrats may be in a better negotiating position if a deal is struck not this month, when such an agreement might be labeled a tax increase, but in January after the Bush-era tax cuts have expired, when the same agreement would be called a tax cut.

Facing diminished political leverage, some Republicans, such as Sens. Bob Corker (R-TN), Saxby Chambliss (R-GA), and Lindsay Graham (R-SC) and Rep. Tom Cole (R-OK), are beginning to encourage their leaders to cut a deal before the end of the year. While Boehner has begun to show some flexibility, however, it is not clear if the rest of the House Republican caucus is willing to follow him on raising rates.

Rep. Chris Van Hollen (D-MD) has speculated that Boehner may be waiting until after Jan. 3, when the official vote on his speakership will occur and after which he would be safe from political retribution from the far right wing of his own party. While Boehner easily won nomination in a Republicans party caucus in November, he could still be denied the speakership if just a few dozen Republicans refuse to support him in the final vote in January. This could open the way for another Republican to challenge Boehner for the speakership.

What's In the "Fiscal Cliff"?

What happens if no deal is struck before January? The fiscal cliff includes several components. On the tax side, Bush-era income tax rate cuts will expire. This would affect both middle-class and upper-income taxpayers. Current rates of 10, 15, 25, 28, 33, and 35 percent would rise to 15, 28, 31, 36, and 39.6 percent.

The capital gains tax rate on assets held longer than a year would rise from 15 to 20 percent. Dividends would be taxed as ordinary income. The estate tax would roll back to Clinton-era levels, with a top rate of 55 percent imposed on estates valued at more than $2 million for a couple (about 98 percent of estates would still be exempt if this happened).

The Alternative Minimum Tax (AMT) would affect an estimated 26 million additional taxpayers, and a two percent payroll tax cut (taken out of the employee share of Social Security taxes) would expire. A variety of low-income tax credits, such as the child tax credit and the earned income tax credit, would also be rolled back to earlier levels, along with a number of tax cuts for businesses.

On the spending side, $109 billion in across-the-board spending cuts (called "sequestration") would be divided equally between defense and non-defense programs, although many entitlement programs, such as Social Security and Medicaid, are exempt. Medicare is subject to sequestration, but the cuts would be limited to two percent and would be limited to provider and health plan payments. Sequestration would not affect benefits for Medicare recipients. If sequestration occurs, other non-exempt programs would be cut by amounts ranging from 7.6 to 10 percent.

The Congressional Budget Office (CBO) has estimated that, together, these changes would reduce the budget deficit in 2013 by about $600 billion, cutting the annual deficit by more than half. However, CBO also estimates that these abrupt policy changes would send the economy into a mild recession sometime in the first half of 2013, with slow growth returning later in the year.

These budgetary and economic estimates, however, assume that all of the above policy changes become permanent, which appears highly unlikely. Even if a deal is not reached before Jan. 1, Congress and the administration seem likely to reach a deal by February, when the federal government will be approaching the debt ceiling.

Breaching the debt ceiling would cause far more economic damage than going over the fiscal cliff because it would force the administration to choose which bills to pay and could lead to a default on the national debt. While some analysts have suggested that the administration might be able to unilaterally raise the debt ceiling by citing the 14th Amendment, which says that the nation's debt "shall not be questioned," the Obama administration has publicly rejected that option. For these reasons, combined with the likelihood of increasing instability in the financial markets, a prolonged disagreement lasting well into January seems unlikely.

In the meantime, if necessary, the administration has substantial authority to mitigate the worst of the fiscal cliff's impacts for several weeks. On the tax side, the Treasury Department has authority to preserve current levels of tax withholding. Although some expired tax provisions, such as limits on the AMT, would affect tax filings in 2013, the IRS has indicated that the primary impact is that this would delay the start of the tax filing season by six to eight weeks. It is not likely to cause additional taxpayers to pay the AMT.

On the spending side, the administration has authority to mitigate sequestration (across-the-board spending cuts) by regulating the speed of federal spending through a process called "apportionment." Moreover, agencies commonly make similar adjustments themselves – husbanding resources early in the budget year – because Congress rarely completes its budget work on time, instead passing continuing resolutions to fund federal agencies temporarily. Under such circumstances, existing grants and contracts are likely to be unaffected, although new grants and contracts may be delayed until later in the year. Some federal employees may be furloughed, although the administration has explicit authority to accelerate spending to avoid furloughs if it chooses. These options are described in more detail in a recent OMB Watch analysis entitled Mitigating the Impact of a Temporary Sequester.

While the above options are available to the administration, however, there is no assurance that the administration will actually use them. If budget negotiations extend into January, the administration may decide not to use them, thereby ratcheting up pressure on Congress for a deal.

Current Proposals

If a deal is reached, what would it look like? That is not yet clear, but both the president and House Republicans have put offers on the table and each side has come closer to the other in negotiations over the past several days.

On Dec. 14, Boehner offered a deal with $1 trillion in new revenues over ten years, including $460 billion from allowing Bush-era tax cuts to expire for those making more than $1 million per year. The Speaker also supported cutting spending by $1 trillion, including adopting a new inflation adjustment measure, called the “chained CPI,” that would reduce Social Security benefits. There also appears to be support among Republicans for increasing the eligibility age for Medicare recipients from 65 to 67.

On Dec. 17, President Obama counter-offered with a deal that includes $1.2 trillion in revenues and $1.22 trillion in spending cuts, $290 billion of which would come from savings from the interest on the national debt due to reduced borrowing. On the tax side, the proposal includes permanently extending Bush-era tax cuts on those making less than $400,000 per year, rolling the estate tax back to 2009 levels, taxing capital gains and dividends at 20 percent, and setting a 28 percent cap on most tax deductions except charitable contributions, which would be allowed a maximum tax deduction of 35 percent. The president's plan also includes an adjustment to the AMT, preventing it from affecting middle-class taxpayers. It does not include an extension of the payroll tax cut, which the president had previously supported, but it does propose making permanent recent expansions in the child tax credit and earned income tax credit (EITC).

On the spending side, the president has proposed cutting $600 billion from mandatory spending programs, including $400 billion from health care programs (mostly Medicare), with most of the savings coming from reduced payments to health care providers and drug makers. His plan also includes $200 billion in cuts to discretionary programs, split evenly between defense and non-defense programs. It prevents across-the-board cuts in spending (called sequestration) that would otherwise take place in 2013. It saves another $130 billion by adjusting the consumer price index, though it is not yet clear which programs this proposal would affect. It also extends unemployment insurance benefits, sets aside $50 billion for an infrastructure bank, and increases the debt limit for two more years.

What’s Next?

Chances have increased that a deal will be reached soon between the president and Speaker Boehner. It is less clear, however, whether rank-and-file House Republicans and House Democrats will support that deal if it occurs. Conservative organizations like the Club for Growth, Heritage Action, and Americans for Tax Reform have already come out against Boehner's proposed compromise. Unions and other progressive organizations are opposed to cuts in Medicare and Social Security.

One of the lesser known aspects of the fiscal cliff is that, unlike any “grand bargain” budget deal that seems likely to be struck between the president and congressional Republicans, its $600 billion in deficit reduction in fiscal 2013 is achieved overwhelmingly through tax increases. Of the $109 billion in spending cuts, meanwhile, half would be imposed on defense programs. Moreover, many programs, such as Social Security, Medicaid, Temporary Assistance for Needy Families (TANF), SNAP (food stamps), and a host of others, would be left untouched.

It remains to be seen whether any final deal reached between the president and Congress will be a better deal for the country.

Image by flickr user chbrenchley, used under a Creative Commons license.

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