The unresolved fiscal cliff and the debt nightmare

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Our long national nightmare is over: the fiscal cliff is averted. Well, most of it. But we’ll have another fiscal cliff in two months.

So what happened? First off, some background. The fiscal cliff was a collection of spending cuts and tax increases set to take effect in 2013. The spending cuts included two sets of cuts that were part of the resolution of the 2011 debt ceiling showdown: statutory limits (caps) on discretionary spending and across-the-board cuts (sequestration). They also include expiration of emergency unemployment benefits and automatic cuts to doctor reimbursement rates under Medicare.

The tax increases are a little more complicated. There were five main components: (1) the expiration of the Bush tax cuts (tax cuts enacted under President Bush in 2001 and 2003 but never made permanent), (2) the expiration of the payroll tax holiday (a 2 percentage point tax cut on all wage income intended to boost economic growth), (3) the expiration of 2001 and 2009 expansions in work and child tax credits for low-income families, (4) the expiration of a variety of business tax breaks that are regularly renewed, and (5) the expiration of a confusing technical fix to a obscure tax provision that was intended to ensure that high-income taxpayers paid a minimum tax but, without the technical fix, would raise taxes on many middle-class households.

In total, that’s about $500 billion in spending cuts and $200 billion in tax increases, the equivalent of roughly 4% of GDP. This level of austerity while the economy is continuing to experience a demand shortfall would have caused significant economic damage, and many forecasters - including the Congressional Budget Office, which makes Congress’s official economic projections - were predicting that it would cause the US to fall into a second recession.

The deal that Congress and Obama worked out would waive most elements of the fiscal cliff, thus averting the tax increases and spending cuts, but with some notable exceptions. First, the Bush tax cuts would expire for households with annual income over $450,000 (top 0.7% of households), and tax breaks would be limited for households over $300,000 (roughly top 2%). Second, the payroll tax cut would be allowed to expire, raising taxes on the vast majority of Americans. Third, the caps on discretionary spending would remain in force, and the automatic sequestration cuts would only be waived for two months.

What is perhaps more interesting than how the fiscal cliff got resolved is why it got resolved the way it did. To understand this, one must understand the demands and leverage dynamics of the two negotiating sides, the Democrats and Republicans. As the deal came together, however, it was clear there were four sides: Congressional (House and Senate) Democrats, House Republicans, Senate Republicans, and the White House.

Negotiations started with just President Obama and Republican House Speaker John Boehner. Obama, negotiating for Democrats, had demanded $1.6 trillion in revenue over ten years (roughly $150 billion in 2013). He had proposed specific tax increases - including both tax rate increases (allowing the Bush tax cuts to expire) and limitations of tax breaks - on the top 2.5% of households with income above $250,000 ($200,000 for single filers). He also wanted an extension of unemployment benefits and the payroll tax cut to help the economy (though he never really pushed for the latter), and additional investment in the nation’s infrastructure. Boehner, negotiating for Republicans, demanded an extension of all the Bush tax cuts and significant cuts to social insurance programs like Social Security and Medicare, and other cuts to spending programs.

These negotiating positions obscured strong disagreements within each party on both political strategy and policy. Within each party there were two schools of thought. Some Democrats - including many labor unions, outside progressive groups, and apparently the Democratic leadership in the Senate - believed that the moment offered them tremendous leverage: after all, if no deal was struck then taxes would go up by even more than Democrats wanted. If Republicans refused their demands to raise taxes on the rich, they would simply let all the tax cuts expire and then propose new tax cuts aimed at the middle class. If Republicans assented then Democrats would get what they wanted - expiration of the Bush tax cuts for the rich - and if Republicans refused to pass the new middle class tax cut then Democrats could hammer them for their politically unpopular position in the run-up to the 2014 midterm elections.

Other Democrats, most notably the White House, worried about not getting a deal and “going over the cliff”. After all, the sequestration cuts would do massive damage to domestic spending priorities, and these spending cuts plus the expiration of emergency unemployment benefits and the payroll tax holiday would tank the economy. Progressive think tanks pointed out that most of the cliff wouldn’t fully hit the economy for a few months, especially if the administration directed agencies to continue their current rates of spending. But the White House also worried about how financial markets would respond to failure to strike a deal - a total freak-out could freeze not just the US but also the global economy. Though many Democrats argued that predicting how financial markets would react to hypothetical events is about as accurate as predicting the odds of a land war in Europe, this did not assuage the White House’s concerns.

Republicans faced their own fractures. Speaker Boehner and possibly the Senate Republican leadership clearly felt that Democrats held the leverage and were eager to minimize their losses and retreat to the higher ground of the debt ceiling showdown in February. Accordingly, they preferred to offer a very small amount of revenue from very high-income households starting at $1 million in income and to extend the tax cuts below that threshold. Though they supported cuts to social programs, they knew that Democrats would in turn demand additional revenues in exchange.

This decision, however, seriously rankled the conservative Republican base, especially the freshman House members that were swept into office by the 2010 Tea Party wave. Theirs was an anti-tax movement, and their leadership had not only quickly conceded on raising taxes but also had appeared to demand no spending cuts - or really anything - in return. When Boehner attempted to strengthen his bargaining position by passing a bill that allowed the tax cuts on households above $1 million to expire, these conservatives revolted and Boehner, realizing that the bill would not pass, cancelled the vote.

Though this embarrassment was met with glee from many progressive Democrats who favored a stronger bargaining stance, the White House worried that a weakened Boehner would make it more difficult to pass a bill to resolve the fiscal cliff through the House. Senator Reid was playing hardball with Minority Leader Mitch McConnell, so McConnell reached out to Vice President Biden, who he guessed would reflect the White House’s greater willingness to make a deal. He was correct, and in the waning hours of 2012 they put together a deal that would raise revenues - and more significantly, tax rates - on high income households yet would limit the tax increases to far less than Obama’s initial position.

In the end, the White House got its deal, and Boehner and McConnell minimized the losses. But ironically, though the entire crisis was fueled by the threat that the fiscal cliff posed to the economy, the deal averted less than half of the economic impact of the fiscal cliff. Furthermore, it failed to diffuse the debt ceiling, which poses a far greater threat to the economy and financial markets. The White House has pledged that it will not allow the debt ceiling to be used by the Republicans as leverage, but this will be hard to do now that the sequester is now scheduled to expire at about the same time as the government is projected to hit the debt ceiling. In other words, despite the self-congratulations saturating the nation’s capital, this deal may have planted the seeds for bigger economic catastrophe than it was intended to avoid.