Washington Practices Fiscal Cliff Diving

With tax cuts galore expiring at the end of the year, and steep cuts in both defense spending and discretionary spending on the horizon, Democrats and Republicans in Washington are doing a complicated dance at the edge of the so-called fiscal cliff.

Now that the elections are finally over, there was supposed to be more clarity about exactly what is going to happen with the tax cuts so there could be more certainty for next year. But the posturing is apparently going to continue, as the post-election makeup of the administration and Congress will change remarkably little in 2013.

Yet there have been some encouraging signs. Both President Obama and Speaker of the House John Boehner, R-Ohio, went in front of the cameras last Friday and said they are ready to talk (see Obama Plans Talks with Congress to Avoid Tax Increases and Fiscal Cliff). Boehner has even urged the President to demonstrate his leadership. A meeting has been scheduled between Obama and leaders of the House and Senate from both parties on Friday. On Tuesday, Obama met with the leaders of labor unions and left-leaning advocacy groups to get feedback from them, and on Wednesday he will be meeting with a group of CEOs of major corporations.

So far, though, the two parties remain locked in their original negotiating positions from before the elections. The Obama administration and congressional Democrats largely remain united behind the concept of allowing the Bush tax cuts to expire for couples with incomes above $250,000 a year and individuals making over $200,000 a year, while pushing for an extension of tax cuts for the middle class.

Congressional Republicans contend that allowing the tax cuts to expire at the upper end would hurt small businesses and so-called job creators. Both sides agree, though, that if the tax cuts expire for everybody and aren’t renewed quickly, and if the automatic spending cuts take effect, the country could plunge back into another recession. The Congressional Budget Office estimates that gross domestic product would plummet 0.5 percent next year and unemployment would hit 9.1 percent.

While neither side has any interest in seeing the economy hit the skids, both sides have some leverage in the upcoming negotiations. Obama no longer has to worry about being re-elected and he can claim to have a mandate from the American people. After all, he campaigned on a promise not to allow tax cuts to continue for the wealthy once again, as he was forced to do at the end of 2010 when the Bush tax cuts were in danger of expiring.

Nevertheless, Republicans still control the House, and they will next year too. But chastened by defeats at the polls and a shrinking presence in the Senate, they appear to be ready for some form of compromise, at least for now. That could mean a revival of the so-called “grand bargain” on deficit reduction that Boehner and Obama came close to striking the last time the debt ceiling needed to be raised, as it will need to be lifted again in the next few months. The unconsummated deal reportedly included some form of revenue raising, although Republicans still remain largely opposed to any actual tax rate increases.

What they do seem ready to agree to is limiting tax deductions for the wealthy, as Mitt Romney said he was in favor of doing during the presidential debates. There may be room for a compromise along those lines if Democrats see it as an acceptable substitute for raising tax rates at the upper end of the income scale.

Unless the Bush tax cuts are extended, the top two income tax rates of 36 and 39.6 percent that were in effect during the Clinton administration would return. The Tax Policy Center estimates that the top 1 percent of households, which earn an average of approximately $1.7 million a year, would then need to pay an extra $94,000 in taxes under the budget that Obama has proposed for next year. The Tax Policy Center has also come out with estimates of how much revenue could be raised if tax deductions were limited. The results appear to indicate that a substantial amount of revenue could be produced under different scenarios, perhaps even more than the $700 billion estimated to be gained over 10 years by restoring the top two income tax brackets.

Obama has already supported a plan to limit itemized deductions to 28 percent of gross income for taxpayers who earn over $200,000 a year, so he might be persuaded to agree to a plan for limiting tax deductions instead of raising tax rates. However, he might then face accusations from Democrats of caving in to Republicans once again, and he has vowed not to allow that to happen. It may end up being a game of chicken as both sides try to run out the clock while the time ticks away until the end of the year without a deal in sight.

Realistically, though, Congress and the Obama administration have very little time to make a deal, as the IRS is already warning that the uncertainty over tax rates and the still unpatched Alternative Minimum Tax could play havoc with next tax season (see IRS Warns AMT Could Affect 60 Million Taxpayers Unless Patched). Business leaders are also pressing their representatives in Congress to restore some certainty to the economy, as worries about a future recession are tempering their hiring plans.

Unless they can come up with a deal in the next few weeks, Congress and the administration ultimately may need to end up kicking the proverbial can down the road until sometime next year by agreeing to temporarily extend the current tax rates while assuring the public they will work on achieving some version of tax reform next year. Until that happens, both sides will be loath to give up whatever leverage they have over each other, although the prospect of an imminent deadline could finally force them to agree on a compromise.