Passing Over the "Fiscal Cliff" in Early 2013 Seems Increasingly Likely

While the outcome of the 2012 election will still ultimately decide next steps on the federal budget, a status-quo election that leaves Democrats in control of the presidency and Republicans in control of the House of Representatives seems likely to produce a budget stalemate that will last through the rest of the year and will trigger a “fiscal cliff” of spending cuts and tax increases in the new year.

Unless Congress and the president take action, Bush-era tax cuts are scheduled to expire at the end of 2012 (worth about $500 billion in 2013 alone) and another $109 billion in across-the-board cuts in most spending programs (termed sequestration) are scheduled to become effective at the same time. Despite the pressures being brought to bear on policymakers to cut a broad budget deal to prevent this outcome, no deal may be better than a bad deal, particularly if a better deal can be reached in early 2013.

The current standoff between the two parties is primarily due to their differences over tax policy. Republicans want to extend all of the Bush-era tax cuts, while congressional Democrats and President Obama only want to extend them for couples making less than $250,000 per year. Congressional Republicans consider anything less than a full extension of all of the Bush-era tax cuts to be a tax increase. Many on the GOP side believe that if they hold out long enough, congressional Democrats and President Obama will eventually cave in to their demands, as they last did in 2010 when the Bush tax cuts were extended for an additional two years.

On the other side, many Democrats believe it will be necessary to wait until after Jan. 1, when the tax cuts have expired, to prove that they are serious. Moreover, once the new year comes, tax policies that could previously have been called a tax increase would be considered a tax cut. (The Congressional Budget Office would consider such changes a tax cut now, but its calculations have not substantially changed the politics of the issue.)

The Fiscal “Cliff” Is Really a Fiscal Slope

As Jan. 1 approaches, an increasing number of budget analysts are beginning to recognize that the so-called “fiscal cliff” of pending spending cuts and tax increases may not be as immediately disastrous as the phrase implies. The Center on Budget and Policy Priorities has begun to refer to it as a “fiscal slope.”

Much of the concern traces back to a Congressional Budget Office (CBO) report released in August that indicated that if current policies went into effect as scheduled at the beginning of 2013, the economy would fall into a mild recession in the first half of the year. However, the CBO forecast assumes that the policies will go into effect and stay in effect throughout the year.

In reality, most of the effects will be felt only gradually and may not be felt at all if a new budget package is enacted early in 2013. On the tax side, some of the effects will be felt slowly, such as increased tax withholding, but others, such as increased capital gains taxes, will not be felt until returns are filed. Meanwhile, on the spending side, the administration will have enormous flexibility to mitigate the effects of sequestration on federal programs. If a new budget deal cancels sequestration, as is expected, it will likely be retroactive to Jan. 1, thus negating its impact.

This reality – that the fiscal “cliff” is closer to a “slope” and that it is also reversible – is likely to substantially impact how the current budget impasse is resolved.

How a Budget Deal May Happen

The most important factor – the 2012 elections – has yet to be resolved. No significant action is expected before then. If Gov. Romney is elected, the Bush-era tax cuts would probably be quickly continued, either in late 2012 or early 2013 after his inauguration. Sequestration would be quickly dropped for defense spending and, possibly, non-defense spending, too, to give the new administration time to formulate its own budget plan.

However, if President Obama is reelected in a status-quo election, the budget will probably be resolved very differently. If the president is reelected, his administration is expected to release a new budget plan sometime in mid-November. The proposal, which will probably closely track previous administration budget plans, will serve as a placeholder, preventing the president from being blamed for inaction and putting pressure back on Congress to act before Jan. 1.

While it is possible that Congress may act, this seems unlikely for several reasons. First, most congressional Republicans have pledged not to vote for any budget package that includes tax increases, while the Obama administration and most congressional Democrats are determined not to enact any deal that continues Bush-era tax cuts for high-income taxpayers. Second, while the House and Senate Republican leadership might ordinarily be motivated to cut a deal, they will be facing leadership elections within their own party at that time and will not be able to easily work across party lines for fear of facing a challenge from within their own party. Finally, there will probably not be enough time left for Congress to negotiate a budget deal in the last few weeks of 2012.

After Jan. 1, however, the political dynamics change dramatically. Once the Bush-era tax cuts have expired and tax rates return to Clinton-era levels, compromise proposals that omit tax cuts for upper-income taxpayers and give tax cuts to the middle class will no longer be considered tax increases. Congressional Republicans will face substantial political difficulty opposing a budget proposal that includes middle-class tax cuts and, at the same time, cancels sequestration on both defense and non-defense programs.

Some analysts believe such a deal would occur in two steps. The first step would occur in January. It would terminate sequestration and include modest spending and revenue changes that would serve as a down payment on reducing the federal budget deficit. It would also include rules that would fast-track more significant deficit reduction measures within six months, probably including significant changes in existing tax law and entitlements. Another component, still a major question mark, would be an enforcement mechanism that would be triggered if Congress fails to achieve the targeted level of deficit reduction.

Substantial Challenges Remain

Depending on the outcome of the 2012 elections, the political terrain ahead is potentially more favorable for a positive resolution to the current budget impasse than previously believed, but many obstacles remain.

A new budget plan is reportedly being developed by former Sen. Alan Simpson (R-WY) and former President Bill Clinton’s White House chief of staff, Erskine Bowles. The two co-chaired a national commission set up by President Obama that failed to agree on a plan for consideration by Congress by the end of 2010. Their new plan is reportedly more conservative than the first, containing more cuts in health-related spending. Their efforts are being supported by a major national lobbying effort, called Fix the Debt, co-chaired by former Sen. Judd Gregg (R-NH) and former Pennsylvania Gov. Ed Rendell (D), financially backed by billionaire private equity mogul Peter Peterson, and run out of the Washington, D.C., offices of the Committee for a Responsible Federal Budget.