The Fiscal Cliff

A day after Barack Obama won the election, the stock market fell 2%, its biggest fall in a year. Are higher taxes on dividends and capital gains and tougher treatment of banks and fossil fuels only to be blamed for this fall? Or is it fact that the election failed to resolve the biggest question hanging over the economy: how to deal with the deficit. “Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect. The $7 trillion fiscal cliff is the largest, most immediate domestic problem confronting President Obama and lawmakers in the next two months.

President Obama needs to come up with a solution, fast. Within two months some $700 billion of tax increases and spending cut will kick in. Because it would be so abrupt and arbitrary, the cliff also could throw the United States back into a recession next year, when more than $500 billion will be taken out of the economy. But moving the cliff will still leave the underlying problem intact

The Obama administration and the Congress plan to address these problems in two steps: a small deal and a grand bargain. The smaller deal will be struck by the end of year which would extend most of George W. Bushes’ tax cuts temporarily. The deal will also delay the automatic cuts to defense and other spending, and raise the legal ceiling on issuing new debt. The second step would be a “grand bargain” next year on long-term tax and entitlement reform.

The prospect of such a deal depends heavily on whether the two sides are in any better mood to compromise than they were last year. Both sides want a short-term deal linked to a longer-term one that raises revenue by reforming the tax code and slowing the growth in entitlement spending. During previous failed efforts to reach a grand bargain, both sides agreed, however briefly, to important concessions: Mr. Boehner to raise $800 billion in revenue through tax reform, Mr. Obama to a higher Medicare retirement age and less generous inflation protection for Social Security benefits. They also agreed on some $2 trillion of miscellaneous cuts to defense, Medicaid and other programs.

Another problem is how to ensure in advance that rewriting the tax code and entitlements, which could easily take a year, produces the promised deficit reduction. Despite their high-minded rhetoric, neither Democrats nor Republicans relish the political blow back that comes with cutting entitlements and tax breaks. Either way, there would be no easy way out.