The fiscal cliff looms large. It should. Unless Washington does something, 2013 will face a sudden and automatic fiscal restraint. The shock would almost certainly drive this economy's already enfeebled recovery into recession. It is a frightening prospect, to be sure, but, still, likelihoods suggest that even this 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's testimony on monetary policy, forcefully called Congress' attention to the impending problems and, incidentally, coined the phrase “fiscal cliff.” The Congressional Budget Office (CBO) followed up with a full analysis, concluding that, if something is not done, restrictive automatic fiscal measures in 2013 could exceed $800 billion and force this economy into at least two quarters of decline. And though there is always room to cavil, surely the CBO's analysis and conclusions are reasonable. Severe problems are built into law on both the spending and on the revenue sides of the federal budget.

The biggest item is the expiration of the Bush tax cuts. There is, of course, much dispute on these. President Obama and the Democrats want to continue them for all but the wealthy, who they define as individuals who earn more than $200,000 a year and couples who earn more than $250,000 a year. Republicans want to extend them for all, regardless of income level. But if nothing is done, taxes will increase for all on January 2.  Any relief on alternative minimum tax (AMT) also will disappear. Congress has not even voted this year's usual “patch” to prevent AMT from spreading from the present 4.4 million taxpayers affected by it to 32.9 million. Its impact then would hit with the spring tax session for 2012 taxes.  Combined, these two matters, the end of the Bush tax breaks and AMT, would, according to the CBO, raise 2013 tax burdens by $265 billion.

There is more. The payroll tax holiday that Congress extended in 2011 also would expire in 2013. That would raise taxes an additional $127 billion. Business would lose its ability to expense part of its capital outlays, a change that would raise its tax burden by $87 billion. Estate taxes also would rise, as the exclusion would fall from $5 million to $1 million and the top tax rate would rise to 55% from the present 35%. This change would add another $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's take would rise from 2.9% of wage and salary income at present to 3.8% for those designated as wealthy, and also would extend to dividends, taxable interest, royalties, capital gains, the taxable part of annuities, and taxable gains from the sales of homes, as well as the “carried interest” of some financial principals. Also as part of ACA, the deductible amounts of medical savings accounts would fall and the threshold for the tax deductibility of medical expenses would rise from 7.5% of adjusted gross income to 10%.  The entire effect would, according to the CBO, increase 2013 tax burdens by another $24 billion.

Taxes on investment income also would rise. Currently, Washington takes 15% of long-term capital gains. That, in the absence of some action, would rise to 20%, not counting the added Medicare take, which would take the rate to 23.8%. Taxes on qualified dividends would rise from the current 15% to the rate on ordinary income, which itself would rise to 39.6% from 35%.  Counting the added Medicare levy would take this rate up to 43.5%.  According to the CBO, these further tax impositions, avoiding any double counting for the Medicare and income-tax hikes already accounted for, would add another $50-100 billion to tax liabilities. In total then, the expected tax hike for 2013 would rise upwards of $600 billion, the biggest peacetime tax increase ever.

On the spending side, the biggest item is the budget sequester.  As part of the debt ceiling compromise of 2011, Congress bound itself to automatic spending reductions, mostly on the discretionary side of the budget, if it failed to make strides in fundamental deficit reduction. That failure, according to the CBO, would produce spending cuts for 2013 of some $87 billion. Since emergency unemployment benefits also would end, the year 2013 would see an additional $35 billion in spending cuts. The failure to pass the annual upward adjustment in Medicare doctors' fees, referred to in Congress as the “doc fix,” would hold back spending another $15 billion. On top of these effects, the CBO indicates, without itemizing, that miscellaneous aspects of fiscal restraint would 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 nominal GDP. It is easy to see why the CBO, or any reasonable analyst, would draw severe recessionary implications from the situation.  But it is just such severity that will likely prompt Congress to turn away from the cliff.  Though it is doubtful that that anything substantive will emerge before the election, there is time to act in the final weeks of the year, even if only with temporary measures.

 Washington effect

Actually, for all the disagreements in Washington, the desire to avoid this recessionary effect is strongly bipartisan. A group of Democratic and Republican senators, called the “Gang of Eight,” already is negotiating a $55 billion “down payment” on deficit reduction, to use their language that would shut down the sequestration of discretionary spending and give breathing room for more substantive discussion. As some members of the group noted, a sequester would drive down discretionary funding so far that the Pentagon would have difficulty meeting its obligations. Some have noted that cutbacks would even render federal courts unable to pay jurors and so also unable to conduct jury trials. There is equal, if less well-organized fervor to avoid the full brunt of scheduled tax hikes. House Speaker John Boehner already has proposed simple continuing resolutions to give Congress room to thrash out fundamental tax reform along lines proposed from both sides of the partisan divide. 

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

1)      The first and most straight-forward occurs if Romney wins the White House, especially if the Republicans also capture the Senate. In such an event, Congress would very likely continue with the Bush income and investment tax rates and forgo any sequester at least until mid-2013 to allow the new administration to craft a budget.  Congress, in such an environment, would probably allow the ACA tax hikes to go into effect and allow the extended unemployment benefits to end, as well as the payroll tax holiday. It would also follow long precedent and pass the “doc fix” as well as the AMT “patch” for 2012. Beyond that, the House and Senate would wait on the new administration. 

2)      The second scenario hinges on the possibility of a narrow Obama win, especially if the Republicans also take the Senate. Such an outcome would likely make the president more malleable than in the past. In this case, Washington could avoid the sequestration with a moderate, immediate down payment on deficit reduction, perhaps in line with proposals from the Gang of Eight, and postpone action on tax changes while Congress works on tax reform through its relevant committees. Success in such an environment would depend on Republican willingness to allow some revenue increases and Democratic willingness to address entitlements reform. In other words, it would depend on cooperation from the Tea Party on the Republican side and the left wing of the party on the Democratic side. 

3)      If, in a third scenario, such cooperation proves impossible or Mr. Obama wins by a wide margin and the Democrats keep the Senate, Congress would probably turn to a solution that can only be described as “kick the can down the road.”  It has already made an installment on this approach by funding the government through March 31, 2013. Because in such an environment the still Republican-controlled House could block Democratic preferences on taxes, Congress likely would make continuing resolutions to avoid the major tax hikes and spending cuts while it continues its partisan battles. Even in the absence of continuing resolutions, it could delay changes in withholding tables while it deliberated on a more lasting solution. 

In any of these cases, the blow of automatic fiscal restraint is much softened or lifted altogether. If the reality of less budgetary support for the economy in 2013 is unavoidable, regardless of the election results, the fiscal cliff, of which there is so much legitimate concern, ceases to have the full recessionary force of which the CBO and Chairman Bernanke have rightly warned.