Brinksmanship or Statesmanship: The Looming Fight at the Edge of the “Fiscal Cliff”

After an exhausting contest, the federal government looks more or less the same as it did before the 2012 election: President Obama faces a Republican majority in the House of Representatives, while Democrats hold a majority in the Senate, but lack the super-majority needed to beat back Republican filibusters.  That configuration is a formula for either compromise or gridlock, depending on the negotiating posture all parties take.

The stakes are highest on matters of economic policy, where a so-called “fiscal cliff” of higher taxes and across-the-board spending cuts looms if Congress and the president fail to reach agreement in the next couple of months.  In this column, I explain what the cliff is, how we came to its edge, and why there is no guarantee that our elected leaders will avoid taking us over it.

What Is the Fiscal Cliff?  Part One: Higher Taxes

Commentators sometimes use the term “fiscal cliff” to refer to two different looming deadlines.  The first concerns taxes.  Laws passed by Congress and signed by President Bush in 2001 and 2003 cut federal income taxes for nearly all taxpayers.  In order to reduce the cuts’ apparent long-term fiscal impact, they were slated to expire in 2010, even though many of the cuts’ supporters hoped that they would eventually be made permanent.

In 2008 Candidate Obama campaigned for the presidency on a platform that called for the Bush tax cuts to expire for upper-income earners but to be renewed for the middle class.  When the cuts were actually about to expire, however, Republicans in Congress negotiated a deal with the president under which the tax cuts were extended for everyone for another two years.

In signing that extension, the president made clear that, over the long run, he remained committed to raising taxes back to their pre-Bush rates for upper-income earners.  And indeed, during the recently-concluded presidential election campaign, President Obama once again called for higher taxes on wealthier Americans.  Governor Romney opposed such rate hikes, arguing instead that rates should be cut, with revenue to be made up from the elimination of unspecified deductions and loopholes as well as from the added revenue that Romney believed that an improving economy would generate.

“Elections have consequences” is the familiar mantra of victorious candidates and so, understandably, President Obama and Democrats in Congress argue that with the president’s re-election, the People have signaled that they would like to see the adoption of his proposal to extend Bush-era middle-class tax cuts but not those cuts that benefited upper-income earners.

Predictably, Republicans resist this reading of the election’s meaning.  Speaker of the House John Boehner and others point out that even as Americans re-elected the president, they also returned more or less the same cast of Republicans to control of the House.  If President Obama has a mandate to pursue elimination of the Bush tax cuts for the wealthy, Congressional Republicans say that, by the same logic, they have a mandate to extend those very cuts.

The two-year extension of the Bush tax cuts will expire at the end of this year, unless Congress takes action.  Expiration will mean that just about all federal income taxpayers will see their taxes rise. That is a result that nobody in Washington wants, but if neither side blinks, that could be the result.

The Fiscal Cliff, Part Two: Across-the-Board Spending Cuts

Whereas the tax component of the fiscal cliff has been a decade in the making, the spending component is of more recent vintage.  It is the product of a limited compromise that Democrats and Republicans reached in 2011 to avoid a government shutdown and the possibility that, for the first time in our history, the United States might default on its obligations.

In Spring 2011, the Department of the Treasury indicated that Congress needed to authorize additional borrowing in order to make up the deficit between revenues and authorized expenditures.  On previous occasions when Treasury had made such forecasts, Congress had obliged by raising the borrowing limit in a federal statute commonly known as “the debt ceiling.”  But this time was different.  Tea Party-affiliated Republicans in the House refused to go along with any deal to raise the debt ceiling unless it contained dollar-for-dollar cuts in spending.  President Obama offered to meet the Republicans more than halfway, accepting that deficit reduction would, indeed, have to be part of a debt ceiling increase, and that spending cuts would account for most of the deficit reduction.  But Republicans balked anyway, refusing to accept any deficit- reduction package that included any tax increases.

Accordingly, even though Speaker Boehner and President Obama had reportedly come tantalizingly close to agreement on a “grand bargain,” consisting mostly of spending cuts and some tax increases, Boehner could not sell the deal to his own caucus.  At the eleventh hour, a coalition of Republicans and Democrats in the House reached an agreement to raise the debt ceiling, adopt some spending cuts, and implement further across-the-board spending cuts down the road.  The across-the-board cuts were not expected to go into effect, however, because Congress also created a bipartisan “super-committee” tasked with the job of proposing $1.5 trillion in deficit reduction measures over ten years.

But the super-committee failed for roughly the same reasons that the president and Congress had failed to reach a broad agreement in the summer of 2011.  The super-committee’s Democrats were unwilling to go along with severe cuts to social programs, while its Republicans were unwilling to raise taxes on anyone.  Consequently, the across-the-board spending cuts will occur unless Congress acts soon.

Is Compromise Possible?

Is there any reason to think that Congress and the president will now reach the cliff-avoiding agreement that eluded them and the super-committee last year?  Perhaps.

Notably, the consequences of failure are starker now than ever before.  Dramatic sudden cuts in federal spending, coupled with tax increases, would leave substantially less money in the American economy.  Hence, going over the fiscal cliff could very likely tip the current slow-growth recovery back into recession.

Game theorists sometimes describe a “penalty default” as a means of strongly encouraging agreement.  The core idea is this: Make the consequences of failure to agree—the default outcome—so odious to all parties that they will necessarily come to an agreement to avoid those consequences.  The penalty default of the fiscal cliff could thus motivate the parties’ reaching agreement.

Another factor also points the way towards a possible compromise: As last week’s election results showed, the Tea Party movement now has less support than it did in 2011.  The party that loses a presidential election invariably engages in some soul-searching, and this year that process could result in a softening of the Republicans’ insistence on retaining the Bush tax cuts in their entirety.

Indeed, we have already seen some movement in that direction.  Speaker Boehner has said that House Republicans would be open to a deal that includes some “new revenues.”

Nonetheless, it would be a mistake to read too much into that concession.  Boehner and other Republicans have also said that they do not want to raise marginal tax rates for any Americans.  Absent unrealistic assumptions about economic growth, the only way to increase revenues substantially without raising (or, more precisely, failing to renew reductions in) any tax rates is to eliminate deductions, credits, and other loopholes.

But the recent election campaign shows why that is an unrealistic strategy.  No doubt the Internal Revenue Code contains some wasteful and unfair deductions, credits, and loopholes that could and should be eliminated.  But to generate revenue on the scale necessary to meet Congress’s stated deficit-reduction goals without touching rates, would require eliminating extremely popular deductions—like the home mortgage interest deduction and the dependent child deduction.  There is a reason that Governor Romney never specified how he would generate hundreds of billions of dollars in new tax revenues without raising (much less by lowering) tax rates: It cannot be done in a way that the American people are prepared to accept.

Accordingly, for the time being the Republican softening on taxes may simply be a rhetorical one.

The End Game

Notwithstanding the incentives for compromise that are created by the fiscal cliff, failure very much remains an option.  Consider labor/management relations: Typically, a strike or lockout is worse for both sides than compromise would be.  But we nonetheless see strikes and lockouts occurring routinely, because each side engages in brinksmanship, waiting for the other to blink, and sometimes, neither side does.  There is no reason to think that our elected leaders are immune to this phenomenon.

Indeed, there is a reason why both sides might prefer going over the fiscal cliff to negotiating a compromise deal.  Going over the cliff would enable Republicans to agree to higher tax rates while claiming that they did not “raise” tax rates.  Here’s why: If Congress does nothing this year, the Bush tax cuts will expire and the top marginal rate will go from 35 percent to 39.6 percent.  At that point, Republicans could agree to a deal in which top earners pay, say, 38 percent, while saying that they had actually lowered rates for top earners by nearly two percent, even though agreeing to the same deal today would be seen as raising tax rates by three percent.  The distinction may be entirely semantic, but then, this is politics, in which labels are often more important than substance.

Meanwhile, the president and Congressional Democrats are aware that Republicans may exhibit greater flexibility on taxes after the fiscal cliff has been passed, and therefore, they may think that they can get a better deal by simply waiting.

This entire mess should be avoidable.  Notwithstanding the conventional wisdom to which both parties in Washington adhere, the federal deficit is not a problem in the short term.  Indeed, as neo-Keynesian macroeconomists like my colleague here at Justia’s Verdict, Neil Buchanan, Paul Krugman, and others have repeatedly noted, in the face of a severe economic downturn, austerity policies in Europe have proven predictably counterproductive: shrinking the public sector drives down demand, leading to further contraction, leading to declining tax revenues, leading to further austerity, and so on, in a vicious cycle.

The conventional wisdom is not only wrong but profoundly confused: If austerity really were the solution, rather than the problem, then going over the fiscal cliff—and ushering in a shock of severe austerity—would be a joyride, rather than the likely disaster that everyone predicts.  But even as they recognize the danger that the fiscal cliff poses, policymakers in Washington court a similar disaster by prematurely aiming to rein in spending.  The Democrats’ approach would do less damage than the Republicans’ approach, because domestic spending has a greater multiplier effect than tax breaks for the wealthy do.  But the Democrats have acceded to much of the conventional wisdom by agreeing to large, premature spending cuts.

The best result of the negotiations in Washington may well be one that would be widely regarded as a cop-out: Extend the tax cuts another couple of years, restore spending, raise the debt ceiling, and keep the party going until the recovery is clearly self-sustaining.  Here’s hoping Congress and the president have the courage to cop out.

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