Five reasons America won't fall off the 'fiscal cliff'

The political and economic ramifications are too big for Washington to let the large tax increases and spending cuts take effect. But this doesn't necessarily mean lawmakers will craft a decisive solution to the nation's fiscal woes.

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Relax, America. You can put your parachutes away. Washington isn't likely to take the country over the dreaded "fiscal cliff." Even a capital city as deadlocked and dysfunctional as Washington has been in recent years is not likely to risk a move that has so many economic and political ramifications, according to a wide range of experts.

That is not to say the journey won't be contentious and perhaps a cliffhanger. Don't forget, the same cast of characters is starring in this big-screen epic – either a dark comedy or a thriller, take your pick – that has brought Americans to this point before: Democrats ruling the White House and Senate, and Republicans, including a clique of unyielding conservatives, in power in the House.

Yet analysts on both sides of the aisle believe that doing nothing, which on Jan. 1 would trigger the beginning of $600 billion in tax increases and large cuts to the federal budget, would inflict too much damage on individuals' wallets, on the economy, and on America's standing in the world.

The fiscal cliff, after all, was never intended to be a serious option. The elements of it grew out of years of debt avoidance and budget gimmickry that finally peaked in 2011 with the impasse over raising the federal debt ceiling. After a bipartisan congressional panel failed to agree on spending cuts, Republicans and Democrats added the infamous "sequestration" portion – a series of automatic spending cuts that were so distasteful that lawmakers would be forced to agree on more sensible trims.

While an agreement to avoid the cliff could still prove elusive, many veteran Washington-watchers believe a compromise will be worked out to avoid plunging into the abyss on New Year's Eve.

"America's reputation and its economic stability are threatened dramatically by inaction," says Dan Glickman, a senior fellow at the Bipartisan Policy Center who previously served as President Clinton's secretary of Agriculture. "Except for a few zealots, most people aren't going to want to see that happen."

Some even believe that the looming fiscal cliff will eventually lead to a grand bargain between the White House and Capitol Hill on reforming America's tax code and entitlement programs – setting the tone, perhaps, for other agreements over the next few years on issues from immigration to energy. But let's not get ahead of ourselves. Here are five reasons America won't – or let's say shouldn't – plunge off the fiscal cliff on Jan. 1.

Because of the "R" word.

Many believe the specter of a double-dip recession remains the most important reason that Congress and the president will reach some sort of accommodation by Jan. 1. It's something that neither party wants to see – or be blamed for.

The Congressional Budget Office estimates that with the massive spending cuts and tax increases imposed by the cliff, US gross domestic product would shrink by a half percentage point in 2013. (Some private sector forecasters believe the hit could be even more severe.) That amounts to 2.7 million fewer jobs than the economy would otherwise create by year's end, the CBO says, which would push the unemployment rate, now at 7.9 percent, above 9 percent.

Even without the drag of the cliff, the CBO calculates that the economy will grow an anemic 1.7 percent this year and unemployment will hover around 8 percent. With Europe mired in its own fiscal problems, and the world's other big economy, China, slowing as well, a downturn in the United States could have disastrous global consequences.

"I have to believe that common sense and self-preservation will prevail" in the face of such economic peril, says Maya MacGuineas, president of the Committee for a Responsible Federal Budget and a leading advocate for a grand budget deal styled after the president's debt commission. "It's not going to be easier to fix the problem by putting the country into a recession – quite the opposite."

Because of the impact on pocketbooks.

The tax increases imposed by the cliff on Americans, collectively, would be the highest in six decades as measured by a percentage of the economy. No one who pays income tax would be spared, and many others wouldn't either.

Much of the attention has focused on the expiration of Bush-era tax cuts that would benefit the wealthy. President Obama has indicated he opposes any agreement that would extend tax cuts on those with household incomes above $250,000, while House Speaker John Boehner (R) of Ohio believes allowing higher rates on upper-income Americans would slow job growth. Mr. Boehner has implied that the wealthy could pay more by reducing the tax deductions they receive – but not by increasing their marginal tax rates.

Yet many of the tax increases that would occur if the fiscal cliff takes effect would fall on middle-income Americans. A household earning $50,000 per year, for instance, would see its taxes grow by $2,000 in 2013, according to the Tax Policy Center. That's in addition to the planned expiration of tax credits for low-income earners and college students passed in 2009 as part of the economic stimulus package.

One of the biggest impacts would come from failing to fix the AMT, or alternative minimum tax. When it was first passed, the AMT was designed to prevent rich people from exploiting loopholes to avoid paying income taxes. But because the AMT wasn't indexed for inflation, it has hit more middle-income families over time. While Congress has acted each year to limit how many people are affected by it, an unresolved cliff package would lead to a nearly sevenfold increase in the number of Americans (from 4 million to about 30 million) who would be affected by the law when they file their 2012 income taxes in the new year.

"You will have 30 million angry constituents and they will ask you why," says John Buckley, a professor of tax law at Georgetown University Law School in Washington, who adds: "I don't think Congress can tolerate that."

Because of the 401(k) effect.

While lawmakers can posture all they want over the fiscal cliff, there is one American institution that registers its opinion every day irrespective of the machinations of Washington – Wall Street.

Many analysts expect the stock market to play a role in pressuring the two sides to hatch some sort of agreement. Letting the nation fall off the cliff – or even approach the cliff – could result in a catastrophic drop in the stock market, they say, which would erode people's portfolios and financial institutions' balance sheets.

"If this craters, that means markets crater," says Douglas Holtz-Eakin, a former director of the CBO and president of the conservative American Action Forum. "And that means all that collateral for the banks crater." He thinks the nation would be facing some of the same problems it did in 2008, at the beginning of the financial crisis.

The markets have already been registering their views over this fiscal pivot point, as they did over earlier ones. In the first week after the election, the Standard & Poor's 500 index sank 2.3 percent, in part over anxiety about the higher tax rates on capital gains and dividends if the fiscal cliff isn't fixed.

In 2008, after the House rejected the bank bailout plan (the Troubled Asset Relief Program, or TARP), the Dow Jones Industrial Average dropped more than 700 points. When the legislation returned to the floor days later, the bill drew nearly 60 new supporters and the legislation passed.

"These catastrophic market moves had a major inspirational effect in getting Congress to act," says Mr. Glickman, who is also a former member of the House from Kansas. "The markets are a big factor in this. [Their impact] may be psychological, but if the markets lose confidence I think Congress becomes more reactive to that."

Because of the sharpness of the paring knife.

The cliff, unresolved, would enforce about $100 billion in infamous "sequestration cuts." About half of that would come from military spending and the rest from across-the-board trims in "discretionary" programs, with the exception of a few things like Social Security, veterans' benefits, and children's health insurance. Groups all across the political spectrum are lining up to prevent the indiscriminate pruning. Republicans don't like the huge cuts to military spending, which would amount to about 10 percent, nor do some Democrats, including Defense Secretary Leon Panetta, who has said it would lead to substantial job losses and reductions in major weapons programs.

Federal emergency assistance would be cut about 8 percent, something that would be difficult even without the sodden destruction of superstorm Sandy. The Secret Service, highway funding, health research, air-traffic controllers, the FBI, environmental protection – outlays for all these would be slashed and all have their constituencies.

"Across-the-board cuts are not policy – they are arithmetic," says Tim Westmoreland, a visiting professor at Georgetown Law School and former counsel to the House Subcommittee on Health and the Environment. "They are less than mindless."

This was the intention, of course, to goad lawmakers into making "responsible" spending cuts, under the threat of irresponsible ones. Will it work? At least many in Washington are complaining about the reckless nature of the trims, though that is a long way from being able to agree on which programs to pare back.

Because of the changing political calculus.

One popular view in Washington has been that the election changed nothing. The same parties hang onto the same institutions. Commentators bicker over just what constitutes a mandate – was Mr. Obama's win big enough? What about voters returning a Republican majority in the House?

Yet many lawmakers on Capitol Hill have read the election as an order from the American people: Work together. The question is whether it will translate into a deal on the fiscal cliff. Certainly both parties have at least some incentive to get something done.

Obama is free of the burden of having to face the voters again and will be increasingly mindful of his legacy. Neither he nor congressional Democrats will want to waste the first 18 months of his final term in office, typically the most productive time for a lame-duck president.

The Republicans, too, may be in a more compromising mood. While House Republicans in particular had plenty of incentive to challenge the president leading into the election – to make him a weaker candidate – those calculations have changed with the GOP's losses in 2012 and with the party's concerns about 2014. Republicans have also now lost the White House in four out of the last six elections and the popular vote in five of those contests.

"Boehner wants a compromise as well," says David Walker, head of the Comeback America Initiative, a group that promotes fiscal responsibility. "The Republicans can't be seen as obstructionist on all these issues because that will hurt them in the 2014 election."

Boehner, Obama, and Senate majority leader Harry Reid (D) of Nevada have all sounded conciliatory notes since Election Day, a stark departure from the heated rhetoric of the campaign season. They are being nudged toward some sort of rapprochement by a widening array of outside groups. The business community, for instance, is vowing to play a more vocal role in getting both parties to reach an agreement on the fiscal cliff and to pursue a grand bargain on debt and deficits. Many lawmakers criticized the captains of industry for remaining silent during last summer's fiscal crisis.

"We saw what we did with the debt ceiling, and we're scared to death that the same thing will happen on the fiscal cliff," says Dave Cote, the chief executive officer of Honeywell, who is heading up a coalition of CEOs lobbying Washington for a deal. The group, known as the Fix the Debt campaign, met recently with Obama at the White House.

Still, for all the pressure and practical reasons for fashioning a deal, not everyone is opposed to tumbling into the abyss. Some lawmakers in Washington see political advantage in letting elements of the package go into effect or at least bumping up against the deadline to spur changes.

Many conservative House Republicans vow to fight for the spending cuts they were promised in the summer of 2011 in order to raise the debt ceiling, believing they are necessary to restore the nation's fiscal health.

"What's important is that we not raise taxes, but I think if there's a move to suspend the sequester, I think that's a problem," says Rep. Jim Jordan (R) of Ohio, the outgoing chairman of the Republican Study Committee, the House's largest and most conservative caucus. "The only thing worse than cutting national defense is not cutting anything at all."

Democrats, led publicly by Sen. Patty Murray of Washington, have said they would be willing to go into 2013 with no deal, allowing all the Bush-era tax cuts to expire if Republicans don't concede to one of Obama's enduring demands: that tax rates rise on household income over $250,000. They also argue that by holding out for the new year, and letting the tax rates revert back to their pre-Bush-era levels, it offers Republicans cover for a pledge signed by more than 90 percent of them to never raise taxes. The rates would go up – with no Republican vote – and all votes thereafter would be for tax cuts that both sides want, notably for middle-class Americans and small businesses. There are procedural moves the White House could make, too, to blunt the effect of going into January without a deal. It could direct government agencies to hold off on planned spending cuts until later in the year, or have the Treasury Department manipulate withholding rates to mitigate tax changes. Still, all this would only give the administration a little extra time, and if Republicans didn't capitulate, the risk for Democrats is that stock markets could explode, turning a point of leverage into a liability.

"It seems to me that the pressure is perfectly balanced" between Democrats and Republicans, says J.D. Foster, a senior fellow at the conservative Heritage Foundation.

With the political pressure mounting on all sides, several scenarios exist for how Washington might avoid the fiscal cliff. Many Democrats, led by majority leader Mr. Reid, want to use the fiscal cliff to reach a broader accord on entitlement and tax reform as well as reducing the nation's deficit.

Boehner, however, has offered a more modest hope: a "down payment" of deficit reduction to prove Washington's seriousness to wary credit-rating agencies, which would be attached to guidelines for achieving tax and entitlement reform in 2013.

Veteran Washington-watchers think the speaker's path is more likely because of its limited aspirations for what is already a chaotic session of Congress between now and Christmas. Such a deal would include perhaps $50 billion in deficit reduction, targets for revenue and spending as percentages of GDP, and goals for entitlement reform for congressional committees to work toward in the coming year.

This is the most viable scenario because it gives Congress "an opportunity to fight another day," says Bruce Josten, the US Chamber of Commerce's executive vice president for government affairs. "The real battle between the two parties is tax and entitlement reform."

And it's this fight that will truly test the current mood in Washington. It will not be about avoiding economic catastrophe, but about the most sacred issues for each party: taxes for Republicans and entitlements for Democrats.

"Everyone's in favor of tax reform before they get into specifics," says Rep. Chris Van Hollen (D) of Maryland, the ranking member of the House Budget Committee. "I think there are ways that we can reform the tax code, and we should reform the tax code, but it is not a panacea" for America's economic problems.

While a grand bargain may be difficult to achieve, what worries many analysts is that Washington will do virtually nothing – just enough to resolve the fiscal cliff but not address the nation's debt and deficit problems in a meaningful way.

"Our concern about the cliff is not that we're going to go off it," says Jim Kessler, a co-founder of the center-left group the Third Way. "But that our fear of going off it will convince leaders to do something very modest on the deficit instead of something bold and that we'll miss this opportunity."

If Congress and the White House do come to some substantial accord, however, it could spur progress on other issues, from immigration to education to energy.

"The tone will be set completely over the next 10 weeks," says Mr. Kessler. "If there's a major deal here, the stoppage in the drain has been cleared and a whole series of things can happen."