Flirting with the fiscal cliff: 4 possible outcomes

Dollar sign on top of a cliff.

With the election finally over, Congress and President Obama have turned their attention to avoiding the so-called fiscal cliff, which is good, since it’s now only a few weeks away.

The fiscal cliff refers to a combination of tax increases and government spending cuts scheduled to happen around Jan. 1, 2013. Going over the cliff is expected to send the U.S. economy sliding back into recession, unless our elected leaders are able to reach a new budget deal.

The problem is, it was our leaders’ inability to reach an agreement that got us into this mess in the first place. The budget cuts in the fiscal cliff were put in place after the two parties failed to reach a longer-term deal in the summer of 2011.

The idea was that the spending cuts, combined with expiration of Bush-era and more recent tax relief, would operate like a ticking time bomb, forcing the two parties to find a common solution.

Now time is running out, and, while both sides have proclaimed a renewed willingness to be flexible, they’ve also indicated they remain committed to the key beliefs that led to this logjam.

Democrats still think taxes need to be raised on the wealthiest Americans to bring down the budget deficit. Republicans continue to oppose raising taxes on the wealthy and favor cuts in programs such as Social Security, Medicare and Medicaid.

No one is sure what’s going to happen. But as the clock ticks, there are four possible outcomes that will have a big impact on our savings and how well our retirement plans perform next year.

Possibility 1. They kick the can down the road ... again.

Ever since Republicans gained control of the House of Representatives in the 2010 elections, our government has been divided.

The deep divide over spending and taxes between those Republicans and the Democrats who control the White House and Senate has caused them to reach temporary deals that keep the government running while pushing off most of the big decisions on financial policy.

They could always do it again. The most likely deal would extend the current tax cuts and spending levels for a few months, while also raising the total amount the government can borrow, as negotiations continue.

Republican House Leader John Boehner has already signaled his party may favor such an approach. Democrats, eager to capitalize on the momentum of the party’s victories in the last election, have called for making a deal now.

The problem with this approach is that it solves nothing. The uncertainty that has stirred up the financial markets and made it hard for industry to make long-term plans will continue. Federal budget deficits would continue to swell.

This is why many of the lobbying groups on both sides of the issue agree: They would rather see the country go off the fiscal cliff than simply push off the hard decisions again.

“Going over the cliff would be a problem for a while, but continuing to add to the debt is a problem we would feel for decades,” says Marc Goldwein, policy director for the Committee for a Responsible Federal Budget, a bipartisan group pushing for a compromise.

Possibility 2. We sail over the cliff just briefly.

This may be the most likely outcome given the complexity of the deal the two parties are trying to fashion and the short amount of time they have left to do it.

It may take briefly going past the deadline, which would ratchet up the pressure, to force the two sides to take the final steps toward a compromise. Even if the president and Republican leaders are very close to a deal, they may need a little extra time to iron it out.

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Surveys from three separate consulting firms found that employers expect to give their workers modest raises averaging about 3% in 2013. That's just slightly more than we received the past couple of years and high-achievers can expect a bigger bounce, of course. Click here to read more about what's likely to happen to our wages and salaries next year.
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Analysts have noted that nothing catastrophic automatically happens the day after the deadline.

Yes, tax rates would go up and government spending levels would be cut. But, if a deal seemed imminent, the government and businesses could wait to recalculate tax-withholding. Federal agencies also could delay changes until they saw the bottom line.

The danger, of course, is that sliding over the cliff could backfire: the deadline past, both sides could dig in to see who blinks first.

That means Possibility 2 could turn into Possibility 3, which is where things get serious.

Possibility 3. We sail over the cliff for real.

What would happen if the spending cuts and tax increases take place?

First, payroll taxes will jump. Social Security will move from 4.2% back up to 6.2% on income up to $110,000.

Capital gains and income tax rates would also revert to higher levels. Several tax breaks, including the child credit, would shrink.

Overall, “a typical middle-class family of four would see it taxes rises by $2,200,” according to a recent White House report.

At the same time, the first round of $1.2 trillion in budget cuts, spread out in equal amounts from 2013 to 2021, will go into effect.

Hitting the cliff means an 8.4% cut in most domestic discretionary spending and a cut of around 7.4% in the defense budget. Social Security, Medicare and other social insurance programs are largely exempt.

Over the long term, the combination of tax hikes and spending cuts would take a big bite out of the budget deficit.

But they would also strike hard at the economic recovery. The Congressional Budget Office projects that going over the cliff would push the economy, now growing by about 2% a year, back into recession for the first half of 2013.

Unemployment, now just under 8%, would climb back to 9.1%. Economic growth would return in the second half of the year, yet the U.S. economy would shrink by 0.5% for the year overall. (For more details, go to: http://www.cbo.gov/publication/43694.)

Even if the recession is relatively brief, the budget cuts and tax increases would mean more hard times for millions of Americans. This is why our elected officials need to come up with a better approach.

Possibility 4. They reach a real, long-term deal.

Believe it or not, government can function. Reasonable people can find compromise.

What would a deal look like? It would almost certainly include some tax increases.

President Obama favors keeping income tax rates where they are for those making less than $250,00 a year but letting the top rates return to Clinton-era levels. This means the top rate would climb from 35% to 39.6%. The capital gains rate would move from 15% to 20%.

Republicans have called for closing tax loopholes as an alternative approach. However, some analysts note that raising significant money by closing loopholes would require cutting back on popular middle-class tax breaks such as the mortgage deduction, certain to be politically difficult.

Still, some combination of higher rates and fewer tax breaks seems the obvious compromise. Both sides would be able to bring something back to their supporters.

On the spending side, any deal is likely to include some cuts in entitlement programs, such as Medicare, Medicaid and Social Security.

In the case of Social Security, relatively modest adjustments in the retirement age and payment limits to the wealthiest retirees could be ahead.

The choices for Medicare and Medicaid, which involve payment levels for doctors and coverage for millions of Americans, are more difficult and painful.

The final balance that negotiators strike could not only determine federal spending but the extent of the government safety net for the foreseeable future.

We'll know where we stand in less than a month.