The fiscal cliff looms large. It should. Unless Washington doessomething, 2013 will face a sudden and automatic fiscal restraint.The shock would almost certainly drive this economy's alreadyenfeebled recovery into recession. It is a frighteningprospect, to be sure, but, still, likelihoods suggest that eventhis Congress will steer clear such a cliff.

Warnings on this matter have emerged through several channels.Federal Reserve Board Chairman Ben Bernanke, at last summer'stestimony on monetary policy, forcefully called Congress' attentionto the impending problems and, incidentally, coined the phrase“fiscal cliff.” The Congressional Budget Office (CBO) followedup with a full analysis, concluding that, if something is not done,restrictive automatic fiscal measures in 2013 could exceed $800billion and force this economy into at least two quarters ofdecline. And though there is always room to cavil, surely the CBO'sanalysis and conclusions are reasonable. Severe problems arebuilt into law on both the spending and on the revenue sides of thefederal budget.

The biggest item is the expiration of the Bush tax cuts. Thereis, of course, much dispute on these. President Obama and theDemocrats want to continue them for all but the wealthy, who theydefine as individuals who earn more than $200,000 a year andcouples who earn more than $250,000 a year. Republicans want toextend them for all, regardless of income level. But if nothing isdone, taxes will increase for all on January 2. Any relief onalternative minimum tax (AMT) also will disappear. Congress has noteven voted this year's usual “patch” to prevent AMT from spreadingfrom the present 4.4 million taxpayers affected by it to 32.9million. Its impact then would hit with the spring tax session for2012 taxes. Combined, these two matters, the end of the Bushtax breaks and AMT, would, according to the CBO, raise 2013 taxburdens by $265 billion.

There is more. The payroll tax holiday that Congress extended in2011 also would expire in 2013. That would raise taxes anadditional $127 billion. Business would lose its ability toexpense part of its capital outlays, a change that would raise itstax burden by $87 billion. Estate taxes also would rise, as theexclusion would fall from $5 million to $1 million and the top taxrate would rise to 55% from the present 35%. This change would addanother $30 billion to the nation's overall tax burdens.

Taxes associated with the Affordable Care Act (ACA or Obamacare)also would go into effect for the first time in 2013. Medicare'stake would rise from 2.9% of wage and salary income at present to3.8% for those designated as wealthy, and also would extend todividends, taxable interest, royalties, capital gains, the taxablepart of annuities, and taxable gains from the sales of homes, aswell as the “carried interest” of some financial principals. Alsoas part of ACA, the deductible amounts of medical savings accountswould fall and the threshold for the tax deductibility of medicalexpenses would rise from 7.5% of adjusted gross income to10%. The entire effect would, according to the CBO, increase2013 tax burdens by another $24 billion.

Taxes on investment income also would rise. Currently,Washington takes 15% of long-term capital gains. That, in theabsence of some action, would rise to 20%, not counting the addedMedicare take, which would take the rate to 23.8%. Taxes onqualified dividends would rise from the current 15% to the rate onordinary income, which itself would rise to 39.6% from 35%. Counting the added Medicare levy would take this rate up to43.5%. According to the CBO, these further tax impositions,avoiding any double counting for the Medicare and income-tax hikesalready accounted for, would add another $50-100 billion to taxliabilities. In total then, the expected tax hike for 2013 wouldrise upwards of $600 billion, the biggest peacetime tax increaseever.

On the spending side, the biggest item is the budgetsequester. As part of the debt ceiling compromise of 2011,Congress bound itself to automatic spending reductions, mostly onthe discretionary side of the budget, if it failed to make stridesin fundamental deficit reduction. That failure, according to theCBO, would produce spending cuts for 2013 of some $87 billion.Since emergency unemployment benefits also would end, the year 2013would see an additional $35 billion in spending cuts. The failureto pass the annual upward adjustment in Medicare doctors' fees,referred to in Congress as the “doc fix,” would hold back spendinganother $15 billion. On top of these effects, the CBO indicates,without itemizing, that miscellaneous aspects of fiscal restraintwould amount to another $140 billion.

The sum of all this restraint, rising, as indicated, to some$800 billion, amounts to over 5% of this country's 2012 nominalGDP. It is easy to see why the CBO, or any reasonable analyst,would draw severe recessionary implications from thesituation. But it is just such severity that will likelyprompt Congress to turn away from the cliff. Though it isdoubtful that that anything substantive will emerge before theelection, there is time to act in the final weeks of the year, evenif only with temporary measures.

Washington effect

Actually, for all the disagreements in Washington, thedesire to avoid this recessionary effect is strongly bipartisan. Agroup of Democratic and Republican senators, called the “Gang ofEight,” already is negotiating a $55 billion “down payment” ondeficit reduction, to use their language that would shut down thesequestration of discretionary spending and give breathing room formore substantive discussion. As some members of the group noted, asequester would drive down discretionary funding so far that thePentagon would have difficulty meeting its obligations. Some havenoted that cutbacks would even render federal courts unable to payjurors and so also unable to conduct jury trials. There is equal,if less well-organized fervor to avoid the full brunt of scheduledtax hikes. House Speaker John Boehner already has proposed simplecontinuing resolutions to give Congress room to thrash outfundamental tax reform along lines proposed from both sides of thepartisan divide.

If most people believe that Washington needs to avoid thiseconomic pain, most also look to the election to clarify the mosteffective way to proceed. There are three basic scenarios:

1) The first and moststraight-forward occurs if Romney wins the White House, especiallyif the Republicans also capture the Senate. In such an event,Congress would very likely continue with the Bush income andinvestment tax rates and forgo any sequester at least untilmid-2013 to allow the new administration to craft a budget. Congress, in such an environment, would probably allow the ACA taxhikes to go into effect and allow the extended unemploymentbenefits to end, as well as the payroll tax holiday. It would alsofollow long precedent and pass the “doc fix” as well as the AMT“patch” for 2012. Beyond that, the House and Senate would wait onthe new administration.

2) The second scenario hinges onthe possibility of a narrow Obama win, especially if theRepublicans also take the Senate. Such an outcome would likely makethe president more malleable than in the past. In this case,Washington could avoid the sequestration with a moderate, immediatedown payment on deficit reduction, perhaps in line with proposalsfrom the Gang of Eight, and postpone action on tax changes whileCongress works on tax reform through its relevant committees.Success in such an environment would depend on Republicanwillingness to allow some revenue increases and Democraticwillingness to address entitlements reform. In other words, itwould depend on cooperation from the Tea Party on the Republicanside and the left wing of the party on the Democraticside.

3) If, in a third scenario, suchcooperation proves impossible or Mr. Obama wins by a wide marginand the Democrats keep the Senate, Congress would probably turn toa solution that can only be described as “kick the can down theroad.” It has already made an installment on this approach byfunding the government through March 31, 2013. Because in such anenvironment the still Republican-controlled House could blockDemocratic preferences on taxes, Congress likely would makecontinuing resolutions to avoid the major tax hikes and spendingcuts while it continues its partisan battles. Even in the absenceof continuing resolutions, it could delay changes in withholdingtables while it deliberated on a more lasting solution.

In any of these cases, the blow of automatic fiscal restraint ismuch softened or lifted altogether. If the reality of lessbudgetary support for the economy in 2013 is unavoidable,regardless of the election results, the fiscal cliff, of whichthere is so much legitimate concern, ceases to have the fullrecessionary force of which the CBO and Chairman Bernanke haverightly warned.