The fiscal cliff showdown: 4 ways it could play out

By Yuval Rosenberg

The victory celebrations sure didn’t last long. As soon as the results from Tuesday’s election became official – before, even – politicians, pundits and investors fixed their attention on the next piece of urgent business facing the country: the fiscal cliff.

The focus has been both immediate and intense, as this chart from Bank of America’s Matthew Fleury, via Joe Weisenthal of Business Insider, shows. The number of articles mentioning the cliff has spiked far higher than coverage of the debt ceiling debate ever did.

But all that attention hasn’t moved the debate from earlier hardline positions. In the days after the election, both men spoke about the need for compromise while at the same time, digging in deeper on their respective lines in the sand on those tax increases for families making $250,000 or more. President Obama insists on raising income taxes on high earners while preserving tax cuts for everyone else; John Boehner, GOP House majority leader, insists on keeping the tax cuts for everyone.

The cliff itself involves much more than just those tax increases. It includes a panoply of more than $600 billion worth of spending cuts and tax increases in 2013:

• About $109 billion in defense and domestic spending cuts

• Expiration of the Bush-era income tax rates

• Annual adjustments to the Alternative Minimum Tax

• Expiration of the payroll tax cut introduced under President Obama

• Expiration of more than 70 so-called annual “tax extenders,” including a rise from 15 to 45 percent in the estate tax

• Expiration of unemployment insurance and Medicare “doc fix” reimbursement rate for doctors

• A return to taxing dividends as income rather than capital gains, and an increase in the top capital gains rate from 15 to 20 percent.

The tax increases on high-income earners would deliver about $42 billion in 2013 and create a small 0.1 percent drag on GDP, according to CBO. But it might come at a price. In California, new tax propositions were passed raising state income taxes on high earners by 10.6 percent to 32.2 percent, depending on which of four tax brackets over $250,000 taxpayers fall into. Other states in fiscal straits are likely to follow and the Republicans and some business leaders claim the combination of increases in federal, state and local taxes on wealthy Americans could take a toll on jobs and limit consumer spending. If so, the economy could stall.

And as we saw during the debt-ceiling debate last year, reaching a deal on those various elements isn’t all that matters – the process used to get there counts, too. With that all as a backdrop, here are a few basic scenarios for how the fiscal cliff talks could play out:

A Modest Compromise
A number of analysts still expect Obama and Boehner to strike a deal that averts the year-end pitfalls while leaving the long-term budget issues for 2013. “The most likely scenario, in our view, is that policymakers reach sufficient political compromise in time to avoid most, if not all, potential economic effects of the cliff,” analysts at Standard & Poor’s Ratings Services said after the election.

Any such deal would require one side to back off its position on tax increases for top earners. “In the end, we expect the upper-income portion of the Bush tax cuts will also be extended for another year,” Jim O’Sullivan, chief economist at High Frequency Economics, wrote this week, “but in return Republicans will have to agree to the outline of a longer-term deficit reduction package that includes some increase in revenues as well as spending restraint.” Alternatively, a compromise could extend the Bush-era rates for everyone but the top 2 percent of taxpayers, renew the patch to the Alternative Minimum Tax, eliminate the payroll tax cut and raise the debt ceiling.

But such short-term compromises would require a commitment to tackle entitlement and tax reforms in 2013. "In order to garner Republican support for new revenues, the president must be willing to reduce spending and shore up the entitlement programs that are the primary drivers of our debt," Boehner said after the election.

Kicking the Can Down the Road
Can-kicking is a favorite Washington pastime and some of the comments made since the election suggest that Congress and the president might work out a deal that extends most if not all of the current tax and spending policies three or six months, buying time to work on both the cliff and a broader agreement in 2013. “We won’t solve the problem of our fiscal imbalance overnight, in the midst of a lame duck session of Congress,” Boehner said. But punting, with or without some small compromise, could still have complicating factors.

“Perhaps the two sides could agree to a framework for later negotiations, and postpone the cliff now — some versions of the ‘kick the can’ view argue that this could be a way out. But the lack of trust to date has precluded such options,” Bank of America Merrill Lynch economists Michael Hanson and Ethan Harris wrote Friday.

A Grand Bargain
It’s highly unlikely if not out-and-out impossible to get done by the end of the year, but the president and congressional leaders could revisit the overarching deal they had discussed last year – one that would address not only averting the fiscal cliff but also hashing out a long-term deal that addresses spending, taxes and entitlement changes that would lower the debt by some $4 trillion in the long term. But negotiations on those issues will likely take time, making a big deal much less likely to be hashed out during the lame duck session of Congress. Even so, any lame duck compromise could set the framework for a broader agreement next year. “An extension of the debt ceiling is possible during the lame duck session but any ‘grand bargain’ with big budget reductions is, in our view, unrealistic,” Brian Gardner of boutique investment bank Keefe, Bruyette & Woods wrote after the election. “Entitlement and tax reform are both issues for 2013.”

The ‘Thelma and Louise’ Option
President Obama and John Boehner could still find themselves playing out a decidedly less glitzy version of the final scene from the Susan Sarandon-Geena Davis chick buddy flick. Boehner told ABC News on Thursday that raising tax rates is “unacceptable” and Obama has said he would veto any deal that extends the Bush tax cuts across the board. “If the president insists that income taxes on higher-income Americans must increase next year, and House Republicans insist that they must not, we risk complete deadlock and may at least briefly go off the fiscal cliff at the end of the year,” Nigel Gault, the chief U.S. economist at IHS Global Insight, wrote in a note to clients Thursday.

Some analysts and politicians, primarily on the left, have suggested that going over the cliff might not be economic suicide. Lawmakers could still work out a deal within weeks or months and make it retroactive, potentially mitigating the harmful economic effects. And reaching an agreement might be easier if Republicans could depict any agreement as cutting taxes from Clinton-era rates rather than raising them from Bush-era ones.

But a failure to address the cliff before the end of the year could have serious consequences. The nonpartisan Congressional Budget Office projects that inflation-adjusted GDP will fall by 2.9 percent, all but assuring a recession, and the unemployment rate would jump from 7.9 percent now to 9.1 percent in the fourth quarter of 2013. And while the CBO projects that the recession would be mild and the economy would grow much more strongly between 2014 and 2017, other economists forecast that the sudden austerity involved with going over the cliff could cause a much stronger economic shock.

Besides sending us back into recession, the continued political gridlock would also shake the confidence of investors and business executives and might earn the U.S. another credit-rating downgrade. “This would be a recipe for turmoil in the financial markets, and would threaten such a severe shock to the economy that the pressure to come to some sort of compromise would be extreme,” Gault wrote.

Whatever the outcome, the odds of going the cliff may be on the rise. “Given that neither party has a majority with which to push through an agenda,” the Standard & Poor’s analysts wrote, “we think the chance that political brinkmanship will push the U.S. economy over the fiscal cliff is increasing, though only to about 15 percent.”

Yuval Rosenberg is a Business+Economy editor at The Fiscal Times. Subscribe to The Fiscal Times' FREE newsletter.

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