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Edging Towards the Fiscal Cliff

On December 31, 2012, the temporary tax cuts instituted during the Bush presidency are due to expire. Most members of Congress don’t want to let that happen; many would like to extend the cuts until a new tax plan can be developed. Republicans want the historically low tax rates from the Bush years to continue. Democrats also want the low tax rates to continue—for most Americans. For the wealthy, Democrats argue, the Bush tax cuts should end. As a result of this difference of opinion, Democrats and Republicans are reaching an impasse—one that brings America ever closer to what pundits are calling the “fiscal cliff.”

The phrase provides a chilling description of what might happen if members of Congress are unable to reach an agreement. If the tax cuts are allowed to expire, taxes will increase by $4 trillion dollars, and government spending will be cut significantly. Allowing the Bush tax cuts to expire could have a disastrous result on securities markets at home and abroad, and yet, that outcome seems increasingly likely, as neither party seems willing to budge.

In fact, some Congressional members from both sides of the aisle are beginning to express the belief that allowing the tax cuts to expire might not be so bad for their respective political parties. That of course, moves the welfare of the American citizen to the back seat. Congress could come back in 2013 and enact new tax cuts. Whomever wins the White House could claim he was responsible for the new tax cuts. It would be a political windfall. Even if that process took all year, the cuts could apply retroactively to January 1, 2013. As a result, the scheduled 2013 tax increases would only exist on paper, and would be wiped out by subsequent cuts. It’s not clear, however, that such a plan would stop Wall Street from reacting: according to the Congressional Budget Office, allowing the tax cuts to expire could plunge the already ailing U.S. economy into a recession in the first quarter of 2013.

For some politicians stepping off the “fiscal cliff” is looking like an increasingly attractive option. It would allow both parties to avoid compromise, and the newly elected president could come to Congress with his new plan.

Members of Congress may be willing to allow the Bush tax cuts to die for another reason: it won’t force them to raise taxes. Voting to increase taxes is never popular in the polls, but if the Bush tax cuts are allowed to die, taxes will increase automatically, generating nearly $4 trillion in revenue. Congress could use some of that money to reduce the deficit, and could give the rest back to voters in the form of new tax reductions. That approach might look good to voters, but is it best for the economy? Unless Democrats and Republicans meet a consensus, the “fiscal cliff” might be inevitable.

An alternative approach would be a short-term extension of the Bush tax cuts, which could potentially buy time for Congress to cut spending and work on a new tax plan. That approach is endorsed by the Republican-controlled House of Representatives, but it is unlikely to pass through the Democratic-controlled Senate, which is pushing for tax rates for the wealthy to expire. Whether that happens largely depends on the outcome of the election.