The messy tax fight that will ruin Christmas

Up and up they go, America's twin pillars of profligacy: The $1.3 trillion annual federal deficit and the $15.7 trillion total national debt. The numbers, so massive that they are nearly incomprehensible, grow ever larger while politicians in Washington blame each other for the mess.

It's about to get messier. Because Republicans and Democrats can't agree on how to soak up this ocean of red ink, automatic tax hikes and spending cuts — enormous and indiscriminate — are scheduled to rock the economy starting in January 2013. There's still time to avoid this meat cleaver approach, but that would necessitate both sides sitting down and having a thoughtful, civil discussion, which seems too much to ask for. Thus, the ax man cometh.

What's scheduled to happen, and what will it mean for the wobbly U.S. economy? Let's have a look:

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Up and up they go, America's twin pillars of profligacy.

Last summer, Congress and President Obama agreed to cut $1 trillion in spending and asked a badly-named "super committee" to come up with another $1.2 trillion by Thanksgiving. If they failed, then the $1.2 trillion would automatically be slashed beginning in January 2013, with sacred cows on both sides (defense and entitlements) getting whacked. Both sides would give something up, which seemed fair. But Republicans are trying to dodge the defense cuts, warning of job losses across all 50 states and most Congressional districts. (This is one reason why wily defense contractors sprinkle jobs around the nation, by the way.)

Already-enacted spending cuts, of course, are already taking a toll on the economy. In the first quarter of 2012, federal spending pulled back 5.6 percent on an annual basis (a big chunk of that from defense), and state and local government spending was reduced 1.2 percent. Many economists partially blame the slowdown in first-quarter GDP on this belt-tightening.

As for taxes: The media seems focused on President Obama's targeting of high-income earners, but if you're a regular Joe, you're going to feel it come January as well. For the past two years, you've been keeping an extra 2 percent in your paycheck thanks to a temporary break on Social Security taxes. But this goes away on New Year's Day. To make up for those lost Social Security funds, by the way, Congress has just been taking from the Treasury — which means the tax cut you've enjoyed has been fueling the deficit.

But most of the tax hikes are aimed at what President Obama (playing the populist in this election year) calls the "haves" — those upper-income earners who he thinks aren't sending enough to the Treasury.

Obama went along with Republicans in extending the Bush tax cuts two years ago, but now says never again. If Congress does nothing, tax rates on high-income earners will automatically rise from the current 35 percent rate to 39.6 percent. Republicans think this would be a disaster, but these were the same rates we had during the boom years of the Clinton-era. Hardly a disaster. The Treasury Department thinks this would bring in an extra $442 billon over the next decade.

And remember, the 39.6 percent rate for high earners might climb even higher if other tax breaks they now enjoy are phased out, as Obama proposes. This would bring in $165 billion over the next 10 years.

Obama also wants to end a Bush-era break on investment income by raising the tax rate on capital gains to 20 percent from 15. He also wants to tax dividends — currently 15 percent — at 39.6 percent. Republicans blast this as class warfare, since the upper-income crowd receives the vast majority of gains from investments. The Treasury thinks these two tax hikes would generate some $242 billion over 10 years.

The president also wants to limit a wide swath of deductions for individuals earning more than $200,000 a year. This could be the biggest honeypot of all: A whopping $584 billion over the next decade.

Add all the Treasury Department's estimates up and it comes to an extra $1.4 trillion over a decade. That's enough to erase the deficit. But the president's budget proposes to keep spending levels, relative to the size of the economy, about where they are today. That level of spending means the debt ceiling will probably have to be raised again next year. And the battle lines are already drawn. Last week, over a lunch of sub sandwiches, Obama told House Speaker John Boehner that he wants a "clean" lifting of the debt ceiling — in other words, no strings attached. Boehner's response: Forget it.

"As long as I'm around here, I'm not going to allow a debt-ceiling increase without doing something serious about the debt," Boehner replied, according to a summary, provided by his office, of the meeting.

So Obama won't cut spending like the Republicans want, and the Republicans won't raise taxes on the wealthy like Obama (and most Americans) want. Another nasty showdown is looming, like the one last summer that resulted in a humiliating downgrade of the government's long-term credit rating. But this one has many more moving parts. There are also disagreements over whether to extend unemployment insurance that need to be resolved, for example.

Here's the odd part: Both sides are so afraid of January's automatic cuts (especially Republican fears about what this could do to defense) that they're beginning to talk deal. Of course, both are waiting to see whether their hands will be strengthened in November. Assuming Democrats hang onto the Senate and Republicans the House, an Obama win would likely make Republicans more willing to go along with tax hikes (Iowa's GOP Sen. Charles Grassley is already urging fellow GOPers to okay some tax increases). On the other hand, a Romney win in November would strengthen the GOP's hand and make them even less willing to raise taxes than they are now. If that's even possible.