Surviving 'Taxmageddon' without maiming economy

By Peter Orszag

The nation is hurtling toward what has been called "Taxmageddon," the enormous tax increases and spending cuts scheduled for the beginning of 2013. At around the same time, we will also be spending some more quality time with our old friend: the debt limit.

No one can yet see a plausible way through the coming storm. But even though they are not particularly inspiring, paths away from catastrophe do exist.

First, some brief background. At the end of this year, all the Bush tax cuts expire -- amounting to about $250 billion a year. The payroll-tax holiday, at more than $100 billion a year, ends too, as do expanded unemployment-insuran​ce benefits. And we face other spending cuts of about $100 billion, from the sequester set up by the 2011 debt-limit deal.

All told, this fiscal tightening adds up to about $500 billion -- or more than 3 percent of gross domestic product. The economy will be in no shape to handle that much of a squeeze. If we do nothing to reduce or stop it, the economy could be thrown back into a recession.

As if that were not challenging enough, we are expected to bump back up against the debt limit, which currently stands at $16.4 trillion. Projections suggest we will approach the limit in the fourth quarter of 2012. Then, the Treasury secretary will take temporary measures to allow continued issuance of debt. The Bipartisan Policy Center estimates those actions will get us to February 2013 -- at which point we will hit the debt-limit wall. If the economy is weaker than expected, it will widen the deficit faster, and we'll hit the wall sooner.

In thinking through the options for getting past this mess, let's assume that, after this fall's elections, the House of Representatives remains Republican. A presidential victory by Mitt Romney would then probably mean that nothing would get done during Congress's lame-duck session at the end of 2012. After all, why shouldn't House Republicans just wait to deal with the incoming Republican president?

After Romney took office, his administration would presumably negotiate a temporary deal to retroactively reinstate the tax cuts to the beginning of 2013, lift the spending reductions and raise the debt limit for a few months. Republicans would then try to pass a budget resolution and use the reconciliation process -- which allows measures to pass with only 51 votes in the Senate, rather than 60 -- to enact substantial and flawed structural reforms to Medicare and Medicaid (like block-granting Medicaid), and large reductions in programs such as food stamps and Pell Grants.

On the other hand, if Barack Obama is re-elected, an attempt may be made to reach a deal before Jan. 1. The key problem with this scenario is that the Obama administration and House Republicans have irreconcilable differences over the Bush tax cuts: The administration insists that the cuts for people with incomes above $250,000 not be extended again, and the House Republicans insist that they must be. With such a sharp line drawn in the sand, it's not clear how a deal could magically happen before the end of the year.

One possibility would be for the two sides to adopt, during the lame-duck session, a "framework" agreement that would set deficit-reduction goals but provide few, if any, specifics. The tax cuts could be extended and the debt limit raised temporarily as negotiators worked out the details.

Two obstacles to such a framework approach immediately come to mind. First, buying a little more time would only push the problems down the road -- until the next deadline approached. Second, even temporary extensions of the tax cuts would require a compromise: Would we extend all of them (presumably, the administration wouldn't want to) or only those for taxpayers with incomes below $250,000 (House Republicans wouldn't like that)?

Given such difficulties, it might not be possible to reach a framework agreement during the lame duck. Then, all the tax cuts would expire. A dramatic scenario, but this, unfortunately, may be the most likely.

In January 2013, the economy would be hit with a major fiscal contraction, market anxiety would rise, and both sides would blame each other for Washington's dysfunction. But there would be a silver lining: The debate could then move away from the question of which tax cuts to extend.

If we get to that point, the administration could step forward with an entirely different concept for decreasing taxes. It could propose, for example, large increases in the payroll- tax holiday and in the standard income-tax deduction. This would reduce taxes for everyone, but do it in a much more progressive fashion than the Bush tax cuts did. The net result of the new tax cuts and the expiration of the Bush ones would be higher taxes for upper-income people, as the administration desires.

The president could then dare the Republicans to vote against the new universal tax cut. Republicans would have a harder time withholding support for such an across-the-board tax cut in early 2013, once the Bush tax cuts are water under the bridge, than they would have had holding firm on extending all the Bush tax cuts in late 2012.

Resolving the tax issue in that way wouldn't be enough to raise the debt limit and waive the sequestration spending cuts. To accomplish those things, House Republicans will demand some changes to entitlement programs. The question is whether they would push only for the relatively modest reforms discussed last summer (such as using the so-called superlative consumer price index to make cost-of-living adjustments in Social Security) or demand bigger structural changes (such as premium support in Medicare).

It's tempting to feel nostalgic for the days when Congress wasn't so polarized, and the confluence of a substantial tax-cut expiration, a huge spending cut and the debt limit would virtually guarantee a major piece of legislation. Taxmageddon highlights how much more challenging our system has become.

In navigating through the coming storm, we need to avoid undue fiscal contraction (and preferably provide additional support to the economy if the unemployment rate remains elevated) but also recognize that enacting a debt-limit increase will require some long-term deficit reduction -- which would be desirable in any case. The coming debate thus shows, once again, the benefit of a dual strategy in which we continue to provide stimulus to the economy in the short run but enact substantial deficit reduction that takes effect down the road.

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