Countdown to Taxmageddon

What is the fiscal cliff?

It's the worst consequence yet of the partisan deadlock in Washington — a combination of $8 trillion in tax hikes and spending cuts scheduled to begin taking effect Jan. 1, 2013. If the country goes off that cliff, economists say, we'll plunge right back into recession. At midnight on Dec. 31, the Bush-era tax cuts are due to expire, raising income tax rates across the board to levels last seen in 2001. President Obama's 2 percent payroll tax holiday will end, too, along with a host of other business and investment tax breaks. All told, four out of five U.S. households would face an average of $3,701 more in taxes next year, according to the Tax Policy Center; the federal government's tax haul would increase by $399 billion. Some have dubbed this threat to the fragile economic recovery "Taxmageddon." At the same time, the first $100 billion in automatic cuts to defense spending and domestic programs such as Medicare will kick in, under an agreement reached last summer by a congressional supercommittee. Together, these measures would squeeze more than $600 billion out of the economy next year alone.

What would be the effect?

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If Congress and the White House don't act, according to the Congressional Budget Office, the massive tax hikes and spending cuts could knock 4 percent off the country's projected economic growth. That would probably mean a 1.3 percent contraction in the first half of the year — a recession. "It's two to three times bigger in negative terms than even the biggest year of the stimulus was in positive terms," said Austan Goolsbee, former chairman of President Obama's Council of Economic Advisers.

Why is this happening now?

For the past three years, Congress and the White House have repeatedly adopted temporary fixes to avoid making real budget or political sacrifices. Washington has kept pushing the day of fiscal reckoning into a future that is finally upon us. In the short term, canceling the tax increases and spending cuts outright might help the economic recovery. But with the U.S. running a $1 trillion annual deficit, preserving the status quo would send our long-term deficit soaring. The CBO estimates that if Congress stops the scheduled tax and budget changes, U.S. public debt, now about 70 percent of the gross domestic product, will climb to 200 percent of GDP by 2037. In light of that, issues that lawmakers have long sidestepped — like ensuring Social Security's viability and controlling Medicare's rising costs — are back on the bargaining table. There is even talk of reviving parts of the 2010 Bowles-Simpson proposal — which both parties ignored — to cut $4 trillion from the deficit by reforming entitlements and eliminating tax breaks.

Where do the parties stand?

Firmly at odds. Republicans are adamant that all of the Bush tax cuts be made permanent, while Democrats insist that tax revenues have to rise to offset spending and reduce the deficit. President Obama has vowed to extend tax cuts only for those making less than $250,000 a year. Republicans, who have pledged not to raise taxes under any circumstances, say that the deficit should be reduced entirely through nonmilitary spending cuts and tax reform that stimulates economic growth.

Is a deal likely?

Not in the next few months. Neither Republicans nor Democrats want to cut a deal before they know who will occupy the White House next year. That gives lame-duck lawmakers less than two months after the election to make a deal before Taxmageddon arrives. Congress could strike another temporary deal that would buy lawmakers time to craft a more comprehensive "grand bargain." But given the yawning gap between the parties' positions, even that may be difficult. "You just don't get the sense that there's even a secret plan yet," said Maya MacGuineas, president of the bipartisan Committee for a Responsible Federal Budget. "It's scary."

Where does that leave us?

As usual, waiting for political leaders to act in the nation's best interests, instead of their own. In the meantime, some businesses say they are cutting spending and delaying hiring out of fear that Congress won't reach a compromise in time. "You don't board up the windows when the hurricane is there," said Bank of America economist Michael Hanson. "You board up the windows in anticipation." Unfortunately, lawmakers feel little public pressure to forge a plan now, rather than when time is nearly up. They know voters are enraged by cuts in government services that benefit them, and at the same time oppose higher taxes to sustain those programs. "In my years of polling, there has never been an issue such as the deficit on which there has been such a consensus among the public about its importance," said Pew Research Center President Andrew Kohut, "and such a lack of agreement about acceptable solutions." Americans, in other words, are getting the government we deserve.

Striking a grand bargain

How Taxmageddon gets resolved depends largely on the election results in November. If Mitt Romney is elected president and Republicans retain the House and take control of the Senate, the Republicans will likely reinstate all the Bush tax cuts, even if they have to wait until Romney's Jan. 20 inauguration to do it retroactively. The GOP would seek to blunt the fiscal damage with deep cuts to Medicare, food stamps, and student loans. If Obama wins re-election, Democrats could let the Bush tax cuts lapse and then reintroduce new tax cuts for the middle class in January 2013, essentially daring Republicans to oppose them. They might also suggest keeping some spending cuts that Republicans favor, and propose new reforms to Social Security and Medicare, in exchange for new tax revenues. But no agreement will come until both sides know how much power they'll have. "Everyone is kind of holding their cards," said Sen. Bob Corker (R-Tenn.). "We realize it's not game time yet."