Political Survival and the “Fiscal Cliff”

This article was originally published by ProEdge Wire. To view the original publication, please click here.

By Jeffery A. Green

The weeks leading up to and immediately following the New Year usually are marked by the hope-filled anticipation of a fresh start. But this New Year, America can anticipate taking a dive off the “fiscal cliff.” In some economists’ analysis of the oncoming morass, the U.S. economy in 2013 will slide back into recession, and unemployment will rise from 8.3% to 9.1%. The global economic outlook is decidedly bearish when also factoring for slowed Chinese economic growth.

The U.S. political calendar only complicates economic concerns. 2012 is a Presidential election year, and Congress will spend weeks out of session during November and December. In fact, Congress and the White House may have as few as 16 legislative days to find a solution to the many problems facing the nation.

However grim the outlook, both parties have a strong incentive to reduce the nation’s deficit — and to prevent the United States from diving off the cliff — immediately after the election or shortly after the New Year. In short, this incentive is political survival.

Politicians must take into account seven big-ticket items, totaling $487 billion in deficit reduction to avert the cliff-dive. The first issue is the expiration of the “Bush tax cuts.” Expiration of these cuts will raise income taxes in all brackets, raise taxes on capital gains and dividends, narrow tax brackets for married couples, and decrease certain tax credits. Moreover, as inflation-adjusted incomes rise, more people will be captured by higher tax brackets and thus the alternative minimum tax. This tax reversion accounts for $225 billion of the total.

While capital gains and dividends tax rates would return to pre-2001 levels, the Affordable Care Act — labeled “Obamacare” by Republicans – would levy a new 3.8% tax. It affects income from interest, dividends, annuities, rents, and income derived from the sale of property. The tax applies to joint filers with a gross income above $250,000 or $200,000 for those filing singly. This tax increase accounts for $18 billion of the total.

Furthermore, for every employer in the United States, a temporary payroll tax (FICA) reduction of 2% will return to pre-2011 levels. Other taxes on businesses will also increase due to the expiration of temporary deductions for equipment purchases and other provisions. Combined, these taxes account for $150 billion in new revenue.

These tax increases take us about four-fifths of the way down the cliff-face of 2013 deficit reduction. With the Budget Control Act, Congress has set strict caps for discretionary spending — that is, spending on any program for which Congress passes an annual appropriations bill. These caps translate into approximately $110 billion in budget cuts in 2013 and will not exclude spending on military operations in Afghanistan.

For mandatory spending programs, certain emergency unemployment compensation payments enacted in February 2012 will expire. Even though the Congressional Budget Office estimates that unemployment will rise in 2013, payment of unemployment benefits will be $34 billion lower than 2012. Similarly, Medicare physician reimbursement rates will decrease 27%. Congress routinely passes legislation to prevent this shortfall, sometimes called the “doc fix.” If these reimbursements are not addressed, spending will decrease a further $10 billion.

While analysts’ predictions for averting the fiscal cliff range from moderately concerning to downright terrifying, three variables serve as good indicators for where the U.S. Government is heading:  (1) who wins the Presidency; (2) who controls the Congress; and (3) whether the parties seek a “Grand Bargain” or address this issue piecemeal.

In the event of a Republican or Democratic sweep of the House of Representatives, the Senate, and the Presidency, the winning party will not be under a great deal of pressure to immediately make a deal in the few legislative days following the election. Purely from a parliamentary point of view, why compromise today when you will have greater leverage tomorrow? While some of the discretionary budget cuts due to sequestration may be enacted as soon as the new fiscal year, these can be retroactively restored by the new Congress at a later date. If the result of the election is a divided government, then the new President or re-elected President will have strong incentives to begin working with Congress immediately. The root of this incentive lies in the third variable.

The various tax increases and spending components to the fiscal cliff fit into three general areas: (1) mandatory spending programs; (2) discretionary spending programs; and (3) taxes. Regardless of who is elected or re-elected in November 2012, very few American politicians would like their first or last policy decision to be slashing mandatory spending — e.g., Medicare or food stamps. If the moral imperative is insufficient, such cuts also tend to hurt re-election prospects and tarnish one’s legacy. Therefore, immediately reversing or mitigating these effects on mandatory spending programs will likely be a top priority for Congress.

Finding the appropriate offsetting funds, either in other budget cuts or additional revenues, will remain a primary sticking point. Appealing to the same sense of political self-preservation as described for mandatory spending, very few American politicians would deliberately plunge an only recently stabilized national economy into a recession and raise unemployment, especially if this is accomplished through indiscriminate cuts to the U.S. military and tax increases on middle- and lower-income families. As such, finding a way to restructure the deficit reduction package in a rational manner or buying additional time to negotiate a solution will likely be the next priority for Congress.

We have seen these last-minute deals and extensions before. While the 2011 debt ceiling negotiations were protracted and bitter, the fact remains that the White House and Congress eventually struck a bargain. It is not difficult to imagine similar bluster and uncertainty in the coming months, but the political incentives to find a solution remain not just intact, but strengthen every day. And that, hopefully, will be enough to avoid fiscal cliff-diving.