Heading Over the Cliff: The Options Now

           The world is supposed to end today if you believe the Mayan prophecy is true. The Mayan ghosts must have been haunting the House chamber last night as Speaker Boehner was forced by recalcitrant Tea Party Republicans to pull his “Plan B” from a vote.  The failure of Plan B, which would have served as a counter to President Obama’s last deficit reduction offer, is now thought by many to seal the nation’s fate: we’re headed over the fiscal cliff and toward another recession.

             Plan B’s principal elements would have renewed the Bush-era tax cuts for all taxpayers with incomes below $1 million, taxed estates at 35% over $5 million, and allowed the payroll tax cut and certain tax credits for low-income Americans to lapse at year end.  The speaker knew the plan was never going to be approved — Senate Majority Leader Harry Reid has said earlier he wouldn’t let the Senate take it up and President Obama had threatened a veto. But presumably the speaker thought by getting the House to approve the extension of the key Bush tax cuts he would be able to shift the blame for the expiration of those cuts at year end to the President, who up to now, appeared to be holding all the political cards.

That presumed strategy now lies in tatters. It is even conceivable that the speaker could lose his position when the House votes on the position January 3.

Now what? Here are several options, from most to least optimistic.

It’s Time for a Deal: The most optimistic spin on Thursday’s events is that the speaker can now say to his Right that he gave them virtually all that they wanted (minus the expiration of the Bush tax cuts on those with incomes above $1 million). He then can go back to the president and cut a deal knowing that he needs only 26 House Republicans to vote with House Democrats on any final deal. That deal was close before the negotiations broke down: the two sides were only a few hundred billion dollars apart on the total tax increases and entitlement cuts in the package, although they differed on the composition. Those differences can be bridged. The disarray among Republicans and possible public reaction to it may even have strengthened Obama’s hand so that he gets a better deal than if Plan B had actually passed.

The Miracle of Christmas (and New Year): Even if the first quasi-Machiavellian scenario isn’t quite true, some combination of a stock market meltdown, Christmas/New Year good cheer, and a much needed break from Washington, may combine to induce the speaker (or his replacement) and the president to agree to a deal that enough Republicans and  Democrats can support. This could happen either before year end, or sometime in early January.

An “Obama Tax Cut”: This is the scenario that reportedly many Democrats wanted all along. The Bush tax cuts would expire and then the president could ask Congress to reenact them for all taxpayers with incomes under $250,000, the president’s initial position in the negotiations and on which he campaigned. This proposal presumably would be supported by all House (and Senate) Democrats and enough Republicans who couldn’t bring themselves to vote against a tax cut to become law.

This tactic wouldn’t entirely avert the cliff, however. The $100 billion annual “sequester” would still happen on schedule, as would the expiration of the payroll tax and extended unemployment compensation. The alternative minimum tax would not be adjusted for inflation, generating a tax hike for roughly 30 million taxpayers for calendar year 2012, the capital gains tax rate would return to 20% and the preferential tax rate on dividends would end. But the extension of the 2001 tax rates for almost all Americans would cushion the economic pain so that the fiscal impact of the “cliff” would be more than cut in half, perhaps averting a recession. But almost certainly, growth in the first half of 2013 would be very slow.

Small Ball: The president and speaker go back to the drawing board and try for a much smaller deal, one that entails less revenue and a lower cut in entitlements in other spending. They each take credit, however, for the $1.4 trillion in savings due to the discretionary spending caps imposed under the Budget Control Act of 2011. The president would also take credit for $800 billion in savings from wind-downs of the two wars, and any interest savings from the deal. The total of all this could approach $4 trillion and thus possibly restore calm to the markets. There are at least two flies in the ointment for this scenario: it might not attract enough support from House members in either party, but especially Republicans, and it may not be substantial enough to calm the markets.

Cliff all the Way: The most pessimistic outcome (or at least the most pessimistic this author can imagine today) is that enough Republicans do not support the Obama tax cut in the House to allow it to go to the Senate and then presumably to the president’s desk. Reluctant House members argue to the public that the Obama plan is a ruse and reflects the president’s refusal to propose serious spending cuts. The House Republicans then up the ante and refuse to extend the debt ceiling without dramatic spending cuts. Although the President could invoke the 14th Amendment’s provisions supporting the validity of the U.S. debt to avert default and keep the government open, this whole sequence of events could severely rattle the markets, consumers, and businesses and drive the U.S. economy into a deep recession.

So which will it be? This author has been optimistic up to now, but admittedly did not account for a Black Swan event like what happened in the House Thursday night. Let’s all hope the holiday season will bring better news soon.

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