The fiscal cliff: Will Obama, Congress cut budget deal?

Richard Wolf, Tim Mullaney and Susan Davis, USA TODAY | USATODAY

WASHINGTON — Five people will gather Friday inside the White House to begin making decisions that could affect the pocketbooks of 315 million Americans.

When President Obama sits down with the Republican and Democratic leaders of Congress, only 46 days will remain before the nation risks plunging over the "fiscal cliff" — a pileup of scheduled tax increases and spending cuts that threaten to drain $560 billion out of the economy next year and derail the recovery.

It will be high-stakes poker, holding the promise of great rewards for an economic rebound if Washington succeeds and the peril of another recession if it fails.

Promise or peril, some Americans are going to feel the pinch. Should Obama get his way, those with annual incomes above $250,000 will face higher tax bills. If Republicans come out on top, tax rates and defense spending will remain the same, but social programs will face budget cuts.

A compromise portends discomfort, most likely in the form of reduced paychecks, jobless benefits and business tax breaks. And a stalemate means higher taxes and reduced federal spending across the board, including at the Pentagon.

That last scenario has Main Street and Wall Street worried. "We think the fiscal cliff would trigger an avoidable and unnecessary recession," says David Riley, head of Fitch Rating's sovereign-debt rating committee, comparing a decision to go over the cliff to a "kamikaze" deficit-cutting mission. "It would impose real costs on real people."

Conversely, a sensible solution to avoid the fiscal cliff and put the nation's finances on a more sustainable path offers lawmakers the chance to latch on to a budding economic recovery. An improving housing market and a blossoming oil and gas market already have economists projecting that the U.S. could add 12 million jobs over four years if policymakers don't mess things up.

"Main Street will come alive. All the lights will be bright, and the economy of this nation will be the envy of the world," says Republican Judd Gregg, former Senate Budget Committee chairman. "We are ready for boom times in the nation if we could just get our fiscal policy under control."

Now that the election is over, and the same cast of characters is left watching the store, the whole world is waiting to see what they do. Businesses fearing another recession are waiting to hire. Workers are wondering if they'll lose a 2-year-long reduction in the payroll taxes that fund Social Security — a break worth $20 a week to the median working family. Domestic and international financial markets are waiting to see if a U.S. recession would further damage a global economy already weakened by European austerity and a marked slowdown in China.

Americans are hopeful but not confident. Two in three of those surveyed in a USA TODAY/Gallup Poll during the past week want the two sides to split their differences, 45% want an equal division between tax increases and spending cuts, 30% want mostly spending cuts and only 10% oppose tax increases altogether. One in three expect negotiations to fail and the economy to tumble over the fiscal cliff.

The cliff is already holding back the recovery, as companies keep capital on the sidelines in fretful anticipation. David Cote, CEO of Honeywell and a member of the commission that recommended nearly $4 trillion in tax increases and spending cuts in 2010, sees it in reduced hiring. Since spring, he has replaced only 25% of the workers who left Honeywell, a decision that has cost about 600 jobs so far.

"The last thing you want is to hire a lot of people and then have to lay them off," Cote says, explaining why the other 75% of people who leave Honeywell are not being replaced. "Capital is a coward."

Democrats cheered by Obama's re-election and small gains for their party in the Senate and House believe they have the upperhand in negotiations, particularly on taxing higher-income Americans. Unions and liberal groups have seized on that advantage with a grass-roots and advertising campaign calling for higher taxes on the wealthy and no reductions in benefits for Social Security, Medicare and Medicaid.

"The game changed (election) night," says Mary Kay Henry, president of the Service Employees International Union, one of several labor leaders to meet with Obama at the White House Tuesday. "We are going to call upon our government to respect the will of the voters."

GOP leaders, including the two who will meet with Obama on Friday — House Speaker John Boehner and Senate Minority Leader Mitch McConnell — want to hold the line on income tax rates and force bigger reductions in benefit programs.

"The president needs to lead," McConnell said Tuesday. "And that means offering a concrete plan that takes into account the fact that half the Congress opposes tax hikes — not because we're selfish or stubborn, but because we know it's the wrong thing to do, because we know it will hurt the economy."

In the middle are fiscal watchdogs, business executives and young Millennials who want a deal, even if it includes tough tax hikes and spending cuts needed to trim annual $1 trillion deficits and control a $16.2 trillion debt. A dozen CEOs get their White House session with Obama today.

"We think the fiscal cliff is the best opportunity Congress has had in decades to solve some of the major economic and fiscal problems this country faces," says Jim Kessler, senior vice president for policy at Third Way, a moderate Democratic think tank. "This is a now-or-never moment that we should embrace."

Scenario 1

A hard landing

As Obama demands higher tax rates for the wealthiest and Republicans insist that won't happen, the two sides could go briefly past Jan. 1 without a deal on most of the expiring tax breaks. That could lead to an economic slowdown and joblessness heading toward 10%. T. Rowe Price chief economist Alan Levenson says Obama can reduce the impact for a short time by ordering the Internal Revenue Service to collect 2013 withholding taxes at 2012 rates.

If Washington fails and all of the fiscal cliff's tax and spending measures stay in effect, the economy would fall into a mild recession in the first half of the year before resuming its weak growth rate in the second, the Congressional Budget Office estimated last week.

Unemployment, now 7.9%, would rise to 9.1% by the end of 2013, it said.

It's unlikely that the downturn, while expected to be short, would be as nasty as the 2008 financial crisis. Financial markets think CBO's forecast is too optimistic, because the economy is only growing a little faster than 2% this year and the cuts could subtract up to 3.6% or more of total economic activity. The International Monetary Fund says "global spillovers would be amplified through negative confidence effects, including, for example, a global drop in stock prices."

Fitch, one of the bond-rating services whose threats to cut the U.S. bond rating is driving pressure to make a deal, says unemployment could top 10%. Both Fitch and Moody's Investors Service say failure to reach even a temporary deal likely would result in a downgrade. The National Association of Manufacturers says going over the cliff could forfeit 6 million jobs and a 10% loss in household income.

"It could be a lot worse than people expect," Cote says.

The non-partisan Tax Policy Center estimates that toppling over the cliff would cost about $3,500 per U.S. household. A typical middle-income family would see taxes rise by about $2,000. Those in the top 1% would pay an additional $120,000, while the average low-income household would pay about $400 more.

Another potential downside for taxpayers: Congress has to decide whether to let the payroll tax cut and extended jobless benefits expire, since both were tied to the recession. Eliminating the payroll tax cut and unemployment benefits could cost the economy 800,000 jobs, CBO says. The Wall Street firm BlackRock estimates it would cut the economy's 2% growth rate in half.

If extended unemployment insurance expires on schedule, 2.1 million Americans would see benefits stop immediately at the end of the year — a "human cliff," says Rep. Sander Levin, D-Mich., top Democrat on the House Ways and Means Committee.

And if lawmakers don't agree to prevent the alternative minimum tax (AMT) from hitting millions of upper-middle-income taxpayers, the IRS might have to delay processing tens of millions of returns in January and February.

Automatic spending cuts would trim about $55 billion, or nearly 10%, from the defense budget next year. While Obama has exempted the armed forces from personnel or pay cuts, more than 100,000 civilian employees could lose their jobs next spring. The defense industry would be forced to downsize, reducing employment among defense contractors gradually, according to the Center for Strategic and Budgetary Assessment. There would be no base closures.

The cuts would cause an equally large reduction in domestic programs, ranging from air-traffic control to agriculture. That could threaten nearly 25,000 Homeland Security jobs, 45,000 cancer screenings for women and 100,000 Head Start placements, according to House Appropriations Committee Democrats. Medicare would be cut by 2%.

Scenario 2

A soft landing

This most likely scenario includes extending most if not all of the Bush tax cuts and making a down payment on spending cuts. The payroll tax cut and extended jobless benefits could expire; the AMT could be patched. A timetable for actions on spending and income taxes would be created.

Leading up to Friday's initial White House meeting, the public appears to be siding with Obama on taxes. Surveys of voters taken on Election Day showed 47% of Americans favor raising individual income taxes on the wealthiest, while 35% want to keep taxes where they are.

Boehner and other Republicans insist that Obama's proposal to push the top income tax rate back up from 35% to 39.6%, where it was under President Clinton, would hurt small-business "job creators" who pay personal tax rates rather than corporate rates. Boehner says it would cost 700,000 jobs.

About three-fourths of U.S. manufacturers, mostly small ones, use personal rates, according to the National Association of Manufacturers. Their average taxable income: $384,000. Under Obama's proposal, a sole proprietor matching their profile would pay about $6,750 more per year.

Restoring payroll taxes to their 2010 level would raise about $115 billion, and ending the extended unemployment insurance benefits would save another $40 billion. Along with spending cuts chosen by negotiators rather than leveled across the board, an interim deal could produce "a down payment of $300 billion to $500 billion to show that we're serious," Cote says.

Because Congress has patched the AMT every year since 1969, it's likely to do so again. Today, the AMT, originally intended to ensure the wealthy pay a minimum income tax, usually hits taxpayers who have a household income over $75,000 and are married with more than two kids, according to Bob Meighan, vice president at TurboTax. It would hit an estimated 28 million for the first time if Congress doesn't act, raising their 2012 tax bills by an average of $3,700.

A compromise deal would reduce growth next year by as much as 1.5 percentage points, says Mark Zandi, chief economist at Moody's Analytics, but would hurt average taxpayers less than many people believe. The recovering economy is nearly ready to pick up that slack, partly because of the improving housing market, rising consumer confidence and the effect that more certainty may have on business investment, he says. Fast-expanding domestic oil and gas supplies are another tailwind that will help the economy, BlackRock vice chair Barbara Novick says.

"It's time," Zandi says. "Our economy is strong enough to digest the fiscal drag. If we lay out a path, the economy will jump."

Scenario 3

A safe landing

The least likely scenario is the opposite of going over the cliff: striking a "grand bargain" during the lame-duck Congress and outlining how to get $3 trillion or more in deficit reduction over the next decade.

Fiscal watchdog groups have joined forces with corporate CEOs to encourage such a deal. The "Fix the Debt" campaign has raised more than $36 million, signed up more than 100 business leaders and built bipartisan support for a balanced deal. More than 300,000 Americans have signed its petitions.

But there are dangers to agreeing on too much, too soon. It could trigger a European-style recession, which could turn policymakers back toward stimulus spending and tax cuts, such as those enacted in 2009.

One key to a long-term deal: eliminating or at least reducing tax deductions and loopholes that cost the government billions. Targets include tax breaks for oil and gas companies, and the wealthy, but some could affect middle-income taxpayers, such as breaks for home mortgage interest and employer-paid health insurance.

"One of the prices to get tax reform is that people are going to have to pay more," Cote says.

The other major part of any grand bargain would be changes to entitlement programs, led by Medicare and Medicaid. Social Security is more likely to be handled separately.

Republicans are looking for an eventual increase in Medicare's retirement age from 65 to 67 and some form of means-testing to collect more from higher-income seniors. Obama last year entertained changes in the Medicare retirement age during talks with Boehner over raising the debt ceiling. Those talks failed, but they form the basis of a new deal.

In an interview with USA TODAY, Boehner puts the problem in historical terms: "The next two years," he says, "are going to be some of the most consequential we've had in 50 or 60 years."