Loose Canons

Fiscal Cliff Diving

Congress looks for a solution -- or at least the appearance of one -- to a problem it created.

By 11.26.12

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Congress returns today to another self-created economic crisis. There will be a lot of high drama on this before they go home for Christmas. Congress has built a mountain of debt, scaled the top, and found that the road back down leads only to a cliff. Now the lemmings -- like Wile E. Coyote, scrambling on thin air -- are wishing for a safety net for themselves -- and, theoretically, our economy -- to catch them before the economy tumbles into a deep recession on January 1.

Before we can understand what's going on in the back-room negotiations, we have to examine the crisis. What is it, how bad is it, and how can it be resolved?

The "fiscal cliff" is a creation of Congress and President Obama. They've already enacted, primarily in the so-called "Budget Control Act" of 2011, a whole raft of economic measures that will go into effect on January 1 unless Congress and Obama can agree on ways to prevent our economy from going over the fiscal cliff they created.

In short, here's what will happen on January 1 unless the lame ducks and Obama make a deal.

First, the Bush-era tax cuts will expire. Which means, for those of us who pay taxes, that the rates will rise from the current 10-35% to 15-39.6%. Long-term capital gains taxes will rise from 15 to 20%. Dividends, now taxed at a lower rate than regular income, will be taxed at the regular income rate.

Second, there are the Obamacare taxes. Investment income will be subjected to a new, and additional, tax of 3.8% to fund Obamacare (and advanced medical equipment, such as CAT-scan machines, will be subject to another separate tax; there's also the "Boehner" tax on tanning beds).

Third, the estate tax will rise from 35% to 55%. So if your estate is valued at more than $5 million, your heirs would benefit greatly if you die before the ball falls in Times Square on New Year's Eve. The new rate will be imposed on much smaller estates, those over $1 million.

Fourth, the wonderful world of sequestration will come upon us in January if Congress and Obama don't act. Sequestration will cut government programs across the board -- damaging our defense, perhaps irreparably -- and reducing some domestic programs. Social Security and Medicare are exempt from sequestration because the Dems and the unions insisted. Those two programs, of course, are what drives our national debt. The debt cannot be reduced unless they are tamed.

Finally, the payroll tax reduction, another "stimulus," will expire on December 31.

As the Congressional Budget Office has forecast, if we fall off the fiscal cliff and all these tax hikes come into effect, we'll be in a below-zero growth economy. Which, by definition, is a recession. Unemployment will grow much higher because industries will lay off many more people than have already been cut. In defense alone, one George Mason University study says that about 1 million jobs will be lost due to sequestration over the next decade.

All told, that's a pretty high cliff to run off.

Congress -- looking for an easy escape -- will probably try to concoct another "if-then" deal of the kind I warned against in 2011 when they were crafting the Budget Control Act. To recap, an "if-then" deal is when the Republicans agree to something that takes effect immediately -- such as a debt ceiling hike or a tax increase -- in return for a Democrat promise to agree to future budget cuts. And, if the past umpteen such deals are a predicate, when the time comes for the Dems to agree to something that will actually happen, they renege.

Before they even get to the "if-then" deal, Congress is apparently considering an increase in federal spending in the fiscal cliff negotiations. Yes, you read that right. In the fiscal cliff negotiations, our wonderful congressional leaders may end up increasing government spending.

Thanks to Sen. Jeff Sessions (R-Ala), ranking Republican on the Senate Budget Committee, we know some of the details. In a November 20 letter to McConnell, Boehner, Reid and Pelosi, Sessions raised a big red flag.

"It is my understanding," he wrote, "that some of the items that may be raised in your fiscal negotiations would increase spending above the levels projected under the Budget Control Act and therefore need to be offset through reductions elsewhere." The items Sessions cites are a one-year continuation of extended unemployment benefits, a continuation of the 2% payroll tax reduction, and modification of the rates paid to physicians under Medicare, which would increase federal spending to a total of $137 billion more than the Budget Control Act allows.

Any increase in federal spending would be simply bizarre in any fiscal cliff deal. For that reason alone we should expect it to happen. And the dealmaking is likely to get a lot worse.

The vultures are already circling. One example already leaked is that some are advocating an increase to the federal gasoline tax. For every one of these vulture tax initiatives that is reported, there will be thirty we don't hear about until after the deal is made.

The outlines of a fiscal cliff deal are easy to forecast, though the details are not. Obama is determined to raise taxes on the rich, and he will probably succeed. His success will be attributable to the urgency that Republicans helped build into the earlier legislation. If they hadn't agreed to the last "if-then" deal in 2011, and hadn't agreed to the automatic nature of the tax hikes in January, they might have avoided this mess. But now they have little leverage: Obama is newly reelected and the calendar is inexorably moving toward January.

Middle class taxes will rise as well, but will be hidden under various disguises such as the Obamacare taxes, dividend taxes, and such. To let the Republicans save face, the Dems will agree that it'll all be stuffed into another pillow sack "if-then" deal.

The Republicans will agree to some tax hikes now in return for entitlement reforms that won't take effect for years to come. The unions -- who are demanding no change in entitlement programs -- will feign outrage at one part of the deal that pretends to make future cuts knowing well that the Dems will not let them happen. And the entitlement program reductions -- maybe in the form of "means testing" or indexing to lower rates -- will be put off for five or ten years.

The Republicans will give up more than they should. "What else can we do?" they'll wail. Actually, a lot can be done if they're willing to take the risks that come from failing to make a deal. It's a risk they have to take.

First and foremost, they have to refuse another "if-then" deal. Anything they agree to -- which shouldn't include any tax hikes or the expiration of any prior tax cuts -- must all take effect now. To the extent that future cuts to entitlement programs and any other government spending are included, these cuts should have to take effect on a date certain. And -- to prevent any Democratic backpedaling -- the legislation should provide that any modifications to the entitlement reductions would have to survive a supermajority vote in both the House and the Senate. By so doing they can make any future action to cancel the cuts very hard to do.

The flip side of this is the sequestration problem. Even if the fiscal cliff deal changes sequestration for 2013, there are still nine more years of sequestration coming -- automatically -- unless the sequestration mechanism is changed. The Dems don't want to stop sequestration on defense, but they do want to stop it on domestic programs. This isn't going to be easy, but the Republicans need to repeal the whole sequestration mechanism so we don't have to do this again and again.

And, lastly, the House Republicans need to keep in mind that come March, they'll have to face another debt ceiling increase. They will have a lot more leverage then than they do now, so it's important to not give in. It'll be easier to force real spending cuts in the next round if -- and only if -- they are willing to risk a government shutdown. That's the only real leverage they have, and -- to date -- they've been unwilling to take the risk.

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About the Author
Jed Babbin served as a Deputy Undersecretary of Defense under George H.W. Bush. He is the author of several bestselling books including Inside the Asylum and In the Words of Our Enemies. You can follow him on Twitter @jedbabbin.