The Fiscal Cliff Compromise

13 Nov

With just 7 weeks left, Congress is faced with a choice of what to do over the looming “Fiscal Cliff”.  The ”Fiscal Cliff” is comprised of a combination of mandatory spending cuts and the expiration of the Bush Tax Cuts.  All of these are set to happen at the same time.  This is a result of the deal struck in 2011 by Congress during the the debt ceiling debates.  The purpose of this measure was to ensure that neither side would wait until now to address the issues it faced.  Rather the hope at the time was that Congress would have addressed the issue before the country faced this challenge and would have come up with a plan to cut the deficit, as well as, found a suitable tax substitute for the expiring tax cuts.

In reality, what we have seen is partisan grandstanding and a childish game of chicken.  This is the same kind of behavior that caused the first credit downgrade in U.S. history.  The downgrade was not done because of the deficit or the total U.S. debt.  It was done as a result of the instability in the U.S. Government.  This instability is the same that we face today and the same we will likely face when the new Congress begins session in 2013.

The key issues separating the side are simple, yet divisive.  The GOP refuses to support tax increases and demands deficit reduction.  The Democrats demand tax increases on the wealthy and refuse to allow reductions to social program spending.  There you have it, that is what separates the two sides.

So what’s at stake if the “Fiscal Cliff” is allowed to happen?

Spending will be slashed dramatically, taxes will rise and the country will likely slip into recession (see chart below for breakdown).  To the average person, this is a no brainer.  To a politician it is not that simple.  Many Republicans in Congress have pledged not to raise taxes.  Others have made promises to reduce the deficit.  These too seem important and many support these things.  Democrats have also promised to reduce deficit spending, but see a different path than Republicans since they are not tied down to a no tax increase pledge.

One more thing, we still must raise the debt ceiling if we want to continue funding the government.  This must happen regardless whether we go over the ”Fiscal Cliff” or not.

If the country is allowed to go over the “Fiscal Cliff”, the impact could be disastrous   Allowing the Bush Tax Cuts to expire, especially on the middle class, would plunge the country’s flagging economy into turmoil.  The spending cuts would also produce a nightmare scenario.  Together, the rise in taxes and the spending cuts would eliminate approximately $600 billion from the economy which would surely drag it back into recession.  

Below is a chart from the non-partisan Congressional Budget Office outlining the potential impacts each portion of the “Fiscal Cliff” would have on the economy.

So what are the options for this Lame-Duck Congress?

Well this depends on who you talk to.  Republicans maintain the plan put forth by Paul Ryan (R-WI), which maintains that you can close loopholes to make up for the revenue needed to avoid the ”Fiscal Cliff” while decreasing the deficit.  This sounds great, except it could potentially jeopardize loopholes and deductions used by middle-class families who rely on those deductions to survive.

Democrats maintain that taxes must be raised on the wealthy in order to reduce the deficit and avoid the ”Fiscal Cliff”.  Republicans won’t support this plan, because it requires that taxes be increased (something that goes against their pledge).

President Obama has already addressed the country telling Congress to get to work on a bill that will avoid the ”Fiscal Cliff”, but clearly stated that he would not sign a bill that gave tax breaks for the wealthy.

It seems as if we have an impasse.  Recently there has been a new option that has come to light.  One that Mitt Romney supported and one that was introduced by the Obama Administration during their failed attempt to fund and pass the American Jobs Act.  This option caps all tax deductions at $50,000 for all.  This would allow any money the government to keep any money not refunded back to tax payers (above the $50,000 in deductions).  For middle class families, this would have little to no impact on their taxes (as can be seen by the graph below).

This option might be a possible path to compromise for Republicans and Democrats.  The increase the Democrats seek would be accounted for using this method and the Republicans could seek shelter here because they wouldn’t technically have agreed to a new tax increase.  This would simply be a reform to the tax code that achieved the same methods of raising taxes without actually doing so.  Of course the Bush Tax Cuts would need to be renewed for all if this method were to be used so this would call for Democrats to come off of their hard lined stance on tax cuts for the wealthy.  The debt ceiling would also have to be increased, but would play a minor role if plans for deficit reduction and taxes can be worked out.

Congress is likely to pursue the latter method, as it is more likely to receive bi-partisan support.  It will not be a surprise, however; if the Republicans and Democrats argue up until the eleventh hour again.

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