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The Tax Compromise That Would Avert the Fiscal Cliff

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The Exchange

By Terry Connelly, dean emeritus of the Ageno School of Business at Golden Gate University

There is a moment in every Road Runner cartoon when Wiley Coyote finds himself standing on thin air having chased his would-be lunch over the cliff — and then he looks down!

That's about where the U.S. economy finds itself today, as reflected in the stock market's nervousness if nothing else, as we wait to find out whether we will go off the "fiscal cliff" when the ball drops this coming New Year's Eve. Like the anvil that inevitably falls from the sky, the doomsday machine that Congress created over the past three years to force itself to adopt a more rational long term plan to pay down the deficit will drop a double-dip recession on the backs of our newly-recovering economy.

Our nation would plunge immediately into a first quarter 2013 economic contraction of up to four percent by Congressional Budget Office estimates, with a knock-on effect increasing unemployment by at least one percent with severely contracting business investment and consumer spending, plunging the rest of the world into similar recessionary patterns or worsening those already affecting most of Europe, and cutting of China's emerging economic recovery at the knees.

Inside the Doomsday Machine

What exactly is the doomsday legislation that Congress concocted to scare itself (and the rest of us, it seems) into reaching an alternative agreement on getting our fiscal house in order? Could just adopting Simpson-Bowles have been that bad compared with this?

Essentially, it's a three-part mechanism, designed to produce about $4 trillion in deficit reduction over the next 10 years, which most powers-that-be in Washington (and more importantly in the credit rating agencies for U.S. Treasury debt) have agreed would be sufficient to constitute an acceptable level of fiscal rectitude. Simpson-Bowles combined spending cuts and tax increases to get to that figure, but Republicans didn't like the tax increases or the absence of healthcare cost savings, and Democrats didn't like their cuts to entitlement programs, so that proposal was shelved.

Meanwhile, we added to the existing debt with two wars, Medicare drug benefits not paid for in taxes, government spending programs on infrastructure and clean energy, and an unemployment benefits extension in order to climb out of the Great Recession following the financial crisis of 2007-08.

After the 2010 election, when the Bush tax cuts were originally intended to expire, Congress agreed to keep them on because we were just beginning to grow GDP again, but set their expiration for the start of 2013, and adopted Obama's two percent payroll tax holiday for employees on a temporary basis again just until 2013. The combined effect of those two expirations would take about $400 billion out of the economy in 2013, raising everyone's income taxes, jumping the rates up on capital gains and dividends and also ending the Alternative Minimum Tax "fix" that keeps that levy from hitting the middle class accidentally.

The elimination of two specific spending programs at the start of next year is also triggered at the New 2013. Also set to hit automatically and the end of extended unemployment benefits — alone saving $40 billion — and the extended reimbursement subsidy to doctors taking Medicare patients, both of which would also pull money from the economy.

Finally, the third part of the doomsday machine are the "sequestration cuts" of about $100 billion, half of each to military spending and "discretionary" domestic spending programs — excepting only Social Security and veterans' payments — which would be cut "across-the-board." As a way to resolve, at least temporarily, the 2011 agony over raising the debt ceiling, Congress set up this automatic structure, which neither party finds acceptable, initially to force a Super Committee of 16 of its members to come up with a better way to cut the $100 billion annually. It couldn't, so the doomsday machine's timer kicked in for New Year's Day as well.

Defusing the Bomb

As is evident, this looming disaster is not the work of Mother Nature like Hurricane Sandy; it is unquestionably a result of "human activity." It is not like the San Andreas fault, it is the politicians' fault (and ours as well, to the extent we refuse to let our own favorites "compromise"). But Congress now has only about 50 days left to turn off the timer and defuse the fiscal bomb.

There is virtually no way a complex package of spending cuts and tax reforms of the type put forth by Simpson-Bowles could be drafted and agreed in that short time. But a substitute set of more rational spending cuts to take the place of automatic "sequestration" is already known by all parties from their 2011 negotiations, which failed over tax cut extension issue. This is a "down payment" on deficit reduction could be a "first step" that could be settled well before New Years.

The tax structure is the tough part because of the divide between Obama and the Democrats, who have insisted that taxes on the highest income groups rise as part of deficit reduction, and Republicans who have opposed even a dime of tax increases for any group, but especially the "job creators" in the top 25 of large-scale small business owners.

There Is Another Way

But Speaker Boehner for the Republicans has proposed post-election that additional revenues could be on the table as part of an overall tax reform agenda that would lower rates for all individuals and corporations. Obama has heretofore insisted that the Bush tax cuts should expire (and thereby tax rates should go up) on individuals with adjusted gross income of $200,00 and couples over $250,000 to balance the overall plan.

But there is another route to the same result, and it's one that not only was proposed in a certain form by candidate Romney and suggested by the president himself in his earliest budget proposals. That route would not be based on higher rates but on capping the level of tax deductions for upper income individuals. Obama proposed this cap on deductions set as a percentage of adjusted gross income — he said 28 percent. Romney proposed doing so by a set dollar amount of $17,000 or $25,000, with persons choosing how to use them in terms of charitable giving, mortgage deductions or state income taxes.

Herein lies the seeds of a real deal, where Obama and the Democrats get their objective of higher tax contributions by the rich, and the Republicans get to keep and even lower the Bush tax rates for everybody, including the rich. Since the devil is in the details of where the actual tax rate and cap rate numbers kick in (not to mention working out the alternative minimum tax effects), we know that the parties could only agree on a framework for such a fix as "step two" to avoiding the fiscal cliff by December 31. That would be enough, along with the spending cut down payment, to stave off a U.S. credit downgrade, relieve the financial markets and get business back to "business."

Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.