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Looming ‘fiscal cliff’ makes election friction look tame

With the election over, voters can take a deep breath. But they had better make it quick. Now the “fiscal cliff” looms. And we’re all headed off it if something doesn’t happen quick.

The path to the cliff was fixed in July 2011, when a debt-limit crisis was averted through a compromise that came with a time bomb whose fuse has now nearly run out.

If Congress cannot forge a compromise by Jan. 1, federal spending will be slashed by $109 billion a year. Half the cuts will hit the defense budget, which will, warns Defense Secretary Leon Panetta, “hollow out the military.”

Meanwhile, taxes will jump across the board. Ninety percent of Americans will see their taxes go up, with those in middle-income brackets facing hikes of roughly $2,000 a year, according to a report by the Tax Policy Center.

Plunging suddenly over this cliff could be catastrophic, almost all analysts agree, tipping the economy into a new recession.

“The short term is harrowing and scary. It’s a big deal,” said Lisa Emsbo-Mattingly, director of research for global asset allocations at Fidelity Asset Management.

But observers on all sides also agree that it is time to actually fix the fiscal mess, not paper it over once again. Some are seizing the moment to generate public pressure for tough fiscal solutions, but there is still huge distance between the left and right on solutions.

Game of chicken

The 2011 debt-limit deal allowed the government to raise the debt ceiling another $2.4 trillion. In exchange, $900 billion in spending cuts would be spread over 10 years. But the poison pill was that a congressional task force would be required to find an additional $1.2 trillion in deficit reductions over those 10 years.

Unless President Barack Obama and Congress agree to an alternative by Jan. 1, 2013, the U.S. will jump the cliff.

All Bush-era tax cuts will expire. Taxes in all brackets will jump, as would corporate and estate taxes. Spending will be slashed, with half the cuts hitting defense.

All this will happen automatically. In beltway jargon, these arbitrary cuts are called “the sequester,” while the whole package of tax hikes and cuts is “the cliff.”

The path to cliff was smoothed by widespread agreement that neither side would actually let it happen.

When the idea was initially hatched back in 2011, Republicans were unwilling to agree to such a proposal. However, they eventually came around to the idea, reporter Bob Woodward wrote in his insider account of the Obama administration, titled “The Price of Politics.”

Speaker of the House John Boehner (R-OH) “told the House Republican leadership and other key members not to worry about the sequester,” Woodward wrote. “‘Guys, this would be devastating to Defense,’” he said. “‘This would be devastating, from their perspective, on their domestic priorities. This is never going to happen.”

But as the presidential contest wore on this fall, no hint of compromise surfaced. Insiders were surprised in the third presidential debate between Obama and Mitt Romney when Obama confidently stated that “the sequester is not something that I’ve proposed. It is something that Congress has proposed. It will not happen.”

Observers were surprised both because, according to Woodward’s unchallenged account, the Obama administration had proposed the sequester approach, and because nothing was yet in the works to avert it.

Meanwhile, the deadline has drawn ever closer. The scope of sequestration damage came into focus when the White House Office of Management and Budget in September outlined the likely impact of the cuts.

“No amount of planning can mitigate the effect of these cuts,” the OMB report read. “Sequestration is a blunt and indiscriminate instrument. It is not the responsible way for our nation to achieve deficit reduction.”

Investor uncertainty

If a solution does emerge before Dec. 31, Emsbo-Mattingly believes it will at first take the form of a six-month breathing space.

If no short-term deal is reached, she fears that over $500 billion in new taxes and $109 billion in spending cuts beginning Jan. 1 will shock the system — much like what occurred in Spain or the UK in recent years.

What Emsbo-Mattingly hopes for is “a credible plan that solves the fiscal problem over the long-term” to give investors confidence and move them off the sidelines.

What investors really need is clarity, she said. “The corporate sector wants to know what game they are playing. Are they playing soccer or baseball? What’s happening now is that the corporate sector is unwilling to play any game because they don’t know what the rules are.”

Pushing the problem off a year ago likely reduced economic growth through investor uncertainty, Emsbo-Mattingly said, and more of the same would lead to more of the same.

In the final analysis, it may be less important what the balance of revenue and spending cuts is, and more important that the mix be reasonably permanent. “It has to be rules-based, and it can’t be gimmicky,” she said. “We’ve seen a lot of gimmicks.”

Emsbo-Mattingly’s biggest fear is that Congress will kick the can down road down again, leaving investors flummoxed in their long-term planning and sidelining their investments.

Business angst

“We don’t need another Band-Aid solution. We need something that will get us back on track,” said Jonathan Romano, spokesman for Fix the Debt, a bipartisan project backed by scores of high-profile civic and business leaders.

Backed by scores of CEOs, Fix the Debt is a well-funded project launched by former U.S. senators Erskine Bowles (D-NC) and Alan Simpson (R-WY) after their 2010 bipartisan budget solution was widely ignored.

“Our goal is to create an environment where voting yes on a comprehensive debt deal is seen as good policy and safe politics,” Romano said.

In addition to fixing Medicare and Medicaid cost explosions, Romano said an acceptable plan should “include a comprehensive, pro-growth tax reform that will broaden the base and lower rates, but also raise revenue and reduce the deficit.”

“We are not endorsing one specific plan. We just want to get back on a sound financial footing,” Romano said. “Everything should be on the table.”

Reaching Compromise

Most business leaders face the onrushing fiscal cliff with angst and agree with the goals of Fix the Debt, but there is still marked resistance to raising taxes.

“Putting America’s fiscal house in order is an urgent priority and we welcome this effort from several top CEOs,” said Bruce Josten, executive vice president (government affairs) of the U.S. Chamber of Commerce, in an email exchange, referring to Fix the Debt.

“We agree that lawmakers must reduce spending, reform entitlement programs like Medicare and Social Security, and pass comprehensive and pro-growth tax reform that would broaden the base, lower rates, raise revenues and reduce the deficit,” Josten said.

But Josten issued no carte blanche on taxes. Raising taxes on “successful small businesses and individuals, investments and capital gains,” he argued, “would discourage capital accumulation and job creation.”

Instead, Josten favors tax code reform, regulatory reform and expanded energy production — all with an eye to stimulating growth.

The Medicare monster

“The government spends about $3.5 trillion a year,” said Rep. Tom Price (R-GA), a member of the House Budget committee. According to him, “$2.5 trillion of that is Medicare, Medicaid, Social Security and interest on the debt.”

Everything else, Price said, is $1 trillion, including defense, against a deficit of $1.3 trillion. “You could do away with the entire federal government except for Medicare, Medicaid and Social Security — and not even balance the budget,” Price said. “That is the magnitude of the challenge we face.

“Medicare reform — saving, strengthening and securing the program — has to be part of moving forward and solving the fiscal challenges. If we don’t address Medicare, we will never get our finances under control.”

Something must give

On the revenue side, one of the biggest chunks on the table is the payroll-deduction tax holiday, which reduces Social Security contributions by 2 percent. Letting that lapse would bring in $135 billion, according to Rep. Price, and he sees no one arguing to keep it.

The other major piece is the Bush-era tax rates, which Price pegs at costing upwards of $150 billion.

But Price does not want to see those rates go up. “I do not think that raising taxes on people out there trying to create jobs in this time of economic challenge is wise at all,” Price said.

GOP resistance to higher income tax rates has flummoxed Rep. Chris Van Hollen (D-MD), ranking member of the House Budget Committee.

Romney had signed the Grover Norquist tax pledge, Van Hollen, observed, a pledge that bound him in writing to “oppose any and all efforts to increase the marginal income tax rates for individuals and/or businesses … and oppose any net reduction or elimination of deductions and credits, unless matched dollar for dollar by further reducing tax rates.”

Asked during the GOP primaries if he would support $10 in cuts for every $1 in revenue, Romney said he would not.

“I think it is indisputable that the president’s plan is closer to the Simpson-Bowles framework than anything the Republicans have put forward,” Van Hollen said, noting that Simpson-Bowles called for just $2 of cuts to $1 of revenue.

“The starting point of tax reform should be to allow the top rate to return to Clinton-era levels. Then we can have a discussion about reducing the rates and broadening the base,” Van Hollen said.

In the short term, Van Hollen hopes to “buy down the sequester” with a short-term compromise that retains the deficit targets but averts the meat-ax cuts. “You could come up with an agreement to replace six months worth of the sequester. That would give you breathing room,” Van Hollen said.

Only then would the real battles begin.