Let’s All Jump Off the Cliff

With less than four weeks left, reaching an agreement to avoid the negative short-term economic impact of the so-called fiscal cliff might be beyond the ability of the strained U.S. political system.

Just kicking the can down the road, averting the more than $600 billion in automatic spending cuts and tax increases scheduled to take effect in January, requires one side to give ground on a core belief: either for Democrats to allow an extension of lower tax rates on top earners or for Republicans to accept a return to higher rates for those taxpayers. It is time to consider a backup plan.

Both parties agree that any deal will include increased revenue. They disagree over the form of that revenue.

Republicans look to limit deductions that mainly benefit people with high incomes, while extending the current 35 percent top income-tax rate. This could raise about $800 billion over 10 years if the deduction cap is broadly applied, but considerably less if tax breaks such as for charitable giving are left untouched or if the cap is phased in gradually to avoid a huge penalty for couples crossing the $250,000 income threshold.

President Barack Obama’s plan raises twice that much through higher tax rates and limits on deductions for households with the top 2 percent of incomes. He would extend current tax rates for lower-income groups.

Democrats and Republicans know that the U.S. fiscal position is unsustainable and that reforms are needed of the tax code and entitlements, yet there is no consensus on which programs should be on the table.

Two Tracks

Our view is that fiscal policy must operate on two time tracks: providing near-term support for the still-fragile recovery, while driving the political system to address the long-term imbalance. We propose to let all tax cuts expire and temporarily offset the negative economic impact.

The changes involved are unsatisfactory to all. Increased revenue comes mainly from higher tax rates rather than from a broader tax base; the higher rates affect all income levels; the alternative-minimum tax hits millions it was never intended to reach; and spending cuts are focused on discretionary programs rather than the entitlements that drive the long-term fiscal imbalance.

To avoid a recession, we propose temporary tax and spending measures to boost near-term demand without making choices between the agendas of the two parties. We see this last point as essential. Getting past the cliff with the least damage to the economy requires not making choices about fundamental long- term issues in a lame-duck setting. This means that our proposal doesn’t separate upper-income tax brackets from other tax rates as sought by President Obama, but neither does it extend all rate cuts as sought by Republicans. Instead, all tax rates go up.

Our proposals are explicitly temporary. We propose a one- year, $200 billion tax refund to support household spending, with rebate checks of about $1,200 for a couple and an additional $600 a child sent out in the first half of 2013. As with a similar measure enacted with bipartisan support in 2008, the tax rebates would phase out for higher-income households, focusing the cash on low- and middle-income households.

We would add $50 billion for spending to rebuild roads, repair and modernize public schools, and fund scientific research. We see a need for a sustained increase in infrastructure spending, even in the face of the long-term fiscal adjustment. This amount is meant as a start, and in recognition that only so many high-quality projects can be initiated in 2013.

Keep Patches

An additional $50 billion would go to fiscal relief for states. This would offset some of the economic drag from their cuts but not erase all budget gaps or remove state governments’ incentives to reach sustainable levels of spending and revenue.

Finally, we propose to extend the legislative patch that prevents the alternative-minimum tax from hitting tens of millions of households and the Medicare “doc fix” that averts sharp cuts in payments to doctors serving senior citizens. We also advocate turning off the sequester put in place in August 2011 that means some $100 billion in automatic spending cuts.

The AMT patch and the doc fix both will be extended under any future fiscal package and aren’t entangled in political conflicts. The spending sequester likewise is opposed by all sides. We think it can be turned off without taking a position on the disagreement over tax rates.

All of these proposals together reduce the contraction from the cliff by $300 billion and add $300 billion to offset the rest of the fiscal tightening and provide the economy with a near-term stimulus. We look to support the recovery and to provide time for a grand bargain to be negotiated on taxes and spending to ensure long-term fiscal sustainability.

At the same time, this isn’t a “least common denominator” approach; the fiscal cliff isn’t avoided, as tax rates rise and expenditures decrease in ways that are painful for people of all political persuasions.

This is an outcome preferred by none. Yet it is better than a stalemate that threatens recession.