Bradley Belt, Jared Bernstein,

William Gale, and Phillip Swagel

The Fiscal cliFF: a BiparTisan survival plan

currenT views | DECEMBER 2012

The Fiscal cliFF: a BiparTisan survival plan

currenT views | DECEMBER 2012

Bradley Belt, Jared Bernstein,

William Gale, and Phillip Swagel

1

hile no one wants the short-term economic damage from the host of tax increases and

spending cuts that will take effect at the end of the year – the “fiscal cliff” – political

conflicts make it difficult to avoid tumbling over the budgetary precipice. This is because even

“kicking the can down the road” requires compromise on a core belief: either for Democrats to

allow an extension of the lower tax rates on top earners or for Republicans to accept a return to

higher rates for those taxpayers.

With the cliff fast approaching, compromise might be beyond the ability of our strained political

system. Both sides agree that increased revenues will be part of the fiscal adjustment but

disagree over the source of those revenues. Republicans look to limit the value of deductions

taken by high-income earners while extending the 35 percent top income tax rate enacted

under President Bush in 2001 and extended by President Obama in late 2010. The idea is to

broaden the tax base but keep rates at current levels for all taxpayers, not just those below the

top income bracket.

President Obama does not believe that enough revenue can be raised from top earners through

base-broadening alone to constitute a credible first step toward the necessary fiscal

adjustment. He seeks to allow for a higher tax rate on households with incomes above

$250,000 for joint filers ($200,000 for an individual) while extending current tax rates for

households below those income levels. Both sides concur that a process is needed in 2013 and

beyond to contemplate reforms of the overall tax code and entitlements, though it is not clear

that lawmakers agree on how this discussion should proceed and which programs should be on

the table.

The purpose of this paper is to consider backup plans in case Congress fails to reach an

agreement. In considering alternatives, it is important to keep in mind that the U.S. fiscal

position is unsustainable. A political bargain that turns off the higher taxes and lower spending

triggered by the deadline—kicking the can down the road—would delay addressing the longer-

term challenge of sustainability. At the same time, the economic recovery remains fragile,

meaning that reform must be gradual to avoid inadvertently undercutting growth. Indeed, the

case for any near-term fiscal retrenchment rests on the idea that such a move is an important

signal that the United States is serious about fiscal reform.

In sum, fiscal policy must operate with two horizons, allowing for near-term support while

putting in place a credible approach to addressing the long-term imbalance over time.

Our view is that the fiscal cliff provides an opportunity to make progress on the challenges of

both horizons. Going over the cliff is no one’s first choice, but doing so moves the federal

budget toward a sustainable path, although with taxes and spending that are unsatisfactory to

W

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all. This gives policymakers the opportunity and the incentive to make future changes. The

opportunity comes in the form of fiscal room to maneuver.

With the expiration of all tax cuts put into place by President Bush and President Obama,

Congress and the president would have much more revenue coming into the Treasury. At the

same time, the changes triggered by going over the fiscal cliff are not ideal from a structural

viewpoint: Revenues increase from higher tax rates rather than from a broader tax base, higher

rates affect taxpayers at all income levels, and cuts focus on discretionary programs that have

already been trimmed rather than the entitlements that drive the long-term fiscal imbalance.

Going over the cliff gives policymakers on both sides considerable motivation to reach common

ground on taxes and spending. Moreover, pressure is applied without congressional action. This

turns the fractious political climate into a feature of the policy approach.

At the same time, we recognize that allowing for the full impact of the cliff would cause

considerable injury to the economic recovery, and it is important to cushion the fall. This is the

case even if the cliff is seen as a “ramp” on which the adverse economic effects of higher taxes

and lower expenditures take hold over time rather than all at once on Jan. 1, 2013 (or even

before then as firms cut back on spending and hiring amid uncertainty over the federal budget

and tax liabilities). In addition to going over the cliff, we then propose temporary tax and

spending measures to boost near-term demand without taking sides in the dispute between

the two parties.

Going over the cliff will be painful for everyone. We look to support economic activity while

setting in place the conditions for an agreement to be reached in 2013. Our approach thus

provides the fiscal room to maneuver and the incentive to agree to further changes consistent

with supporting near-term growth and longer-term fiscal sustainability.

A Three-Part Policy Proposal

Our approach is threefold:

First, we go over the fiscal cliff. Missing the deadline will trigger changes that are not ideal

from the perspective of needed structural reforms: Revenues increase from higher tax rates

rather than from a broader tax base, and spending cuts focus on discretionary programs rather

than entitlements. But at the same time, going over the cliff puts the budget on a better course

for long-term sustainability by raising revenues and reducing spending relative to the current

policy baseline. Taxes rise for all income brackets, child credits are reduced, the payroll tax cut

ends, the alternative minimum tax (AMT) hits millions of households it was never intended to

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reach, the estate tax reverts to a higher level, and so on. This is anathema for all sides, including

for each of the authors of this report.

Second, we propose to enact measures during the lame-duck session to avoid recession in

2013. This calls for a package that is clearly temporary and that avoids political controversies

such as tax changes connected to the Bush or Obama economic agendas or legacies. We see

this last point as essential. With policymakers at a stalemate, getting past the cliff with the least

damage to the economy requires an approach that does not seek to make choices about

fundamental long-term issues in a lame-duck Congress. This means that our proposal does not

separate upper-income tax brackets from other tax rates as sought by President Obama, but

neither does it extend all tax rates that Republican leaders desire. Instead, all rate cuts expire.

We do propose to extend the AMT patch and the Medicare “doc fix” as part of our temporary

fiscal measures, and to turn off the automatic spending cuts forced by the Budget Control Act

sequestration. The AMT patch and the doc fix are not mired in political conflict and therefore

are likely to be extended under any future deal. Similarly, all sides oppose the spending

sequestration; our view is that the sequester can be turned off without taking a position on the

disagreement over taxes.

Third, we give policymakers time to work out a long-term solution. Enacting policies that

temporarily offset the near-term fiscal drag from the cliff provides time for Congress and

President Obama to make thoughtful decisions on taxes and expenditures. We intentionally do

not specify a framework or process. We do not see any such measures as credible, given the

fate of the sequestration in the Budget Control Act.

Discussion

Our proposal is (at most) the third-best option—but this is the nature of a backup plan, since

reaching this point means the first- and second-best outcomes are not attainable.

The ideal solution would be to undertake long-term reforms now (that is, to enact credible

reforms that phase in over time). This would involve setting taxes and spending at levels

consistent with long-term fiscal sustainability and consonant with a national consensus on the

size and role of the government.

The second-best approach would be to make temporary choices that offset the impact of the

fiscal cliff but move toward a long-term solution.

These two “better” approaches involve fundamental choices about U.S. economic policies,

notably about the structure, scale, and composition of revenues and expenditures. It is natural

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that the authors of this proposal differ in their preferred answers to these questions. We all

recognize, however, that it is not realistic to expect a grand bargain on taxes and spending by

the end of 2012 or early 2013. The second-best approach is thus equally impossible, since the

partial steps we individually prefer are at odds with one another. Some of us prefer to extend

all of the 2012 tax rates, while others prefer to extend some rates but not those for upper-

income households. We all recognize the need for adjustments to spending but disagree on

which changes should be made and at what pace. The authors of this paper are thus a

microcosm of the political disagreements in our society.

Our approach is to set aside these conflicts in the context of the fiscal cliff. We see our

proposal as preferable to a stalemate that brings on recession and further undermines investor

and consumer confidence in the political process.

This is not a “least common denominator” approach such as a flat extension of all tax rates

combined with a process solution that is the political equivalent of “pixie dust.” Our proposal

does not avoid the fiscal cliff: Tax rates rise and expenditures decrease across the board in ways

that are distasteful for Americans of most political persuasions. The steps listed below then

offset this impact while avoiding the political gridlock that drove us over the cliff in the first

place. Congress and the president will have an incentive to do better in 2013.

Measures to Offset the Negative Impact of the Cliff

We understand the concern that our approach puts off the economic consequences, with a

concomitant acceptance of a larger deficit than would prevail if we simply went over the cliff

without a policy response. Our larger concern, however, is that such a fiscal retrenchment is

risky now that U.S. economic growth appears to be strengthening but the recovery is not

secure. Deficit reduction must not kick in too soon, or the nation risks ending up back in

recession. We therefore suggest a package that includes greater fiscal support than current

policies, but only for one year. Our proposal then provides incentives for policymakers to agree

on a path by which to address the deficit over time. Those incentives are the unwelcome brew

of taxes and spending triggered by missing the deadline.

The fiscal cliff involves tax increases and spending cuts that together total about $500 billion in

2013. We propose spending and tax cuts that provide near-term support for the economy, as

follows:

$200 billion to $250 billion in refundable personal income tax cuts through increased

deductions that translate into rebate checks sent out in the first half of 2013. As in the February

2008 Economic Stimulus Act, the rebate would phase out for households with incomes above

$75,000/$150,000 (single/joint). This steers the rebates to low- and middle-income households,

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with a threshold set recently with bipartisan support and that differs from the cutoff in the tax

policy debate. A $200 billion cut implies rebate checks of $1,200 for a couple and an additional

$600 per dependent child.

$50 billion to $100 billion in infrastructure spending, split between federal and state

governments. Projects related to transportation, education, and scientific research would be

desirable recipients. We see a need for a sustained increase in infrastructure spending, even in

the face of the long-term fiscal adjustment. This is meant as a start, with the precise amount

depending on how much can be committed to high-quality projects that can begin in 2013.

$50 billion to $100 billion in fiscal relief to states. We are looking for an amount that will offset

the economic drag from state and local budget cuts, but is not so large that these governments

can avoid needed adjustments to reach sustainable levels of spending and revenue.

$100 billion from turning off the automatic spending cuts to defense and non-defense

discretionary programs.

$200 billion to patch the AMT for 2012 and 2013 and to extend the Medicare doc fix for 2013.

This component is supported across the political spectrum and should be part of the policy

baseline.

We recognize the considerable debate regarding extensions of the payroll tax cut (or something

with similar properties) and unemployment insurance benefits. Extending both for one year

would cost just over $100 billion. If these measures are extended, we would expect them to

replace components of the package above such as the personal income tax cuts.

All of us prefer a thoughtful and durable resolution for the fiscal cliff and the longer-term

budget challenges facing the United States. It will be difficult to craft such an agreement before

the fiscal cliff is reached, and even avoiding the cliff will require political compromise. If this

does not happen, the proposal described here is offered as a backup plan. These changes in

taxes and spending are preferred by none and therefore potentially acceptable to all as an

alternative to risking a recession.