The fiscal cliff explained

President Barack Obama speaks about the economy and the deficit in the East Room of the White House. (AP Photo/Pablo Martinez Monsivais)

The fiscal cliff is the story of the moment and the next few months as taxpayers, businesses, defense contractors, local governments and social-service organizations across the country wait to see if they’ll all be taking an economic hit as a result of tax increases and budget cuts – and if the debate over taxes and spending pushes the country back into another recession next year. Those are the expected outcomes if President Obama and Congress can’t come up with a deal to avert those tax hikes and spending cuts.

But let’s step back for a moment and explain what we’re talking about, because the “cliff” is one of those Washington phrases that become so ubiquitous that we often gloss over it without explaining exactly what’s going on. (In fact, the cliff itself is largely an amalgamation of those types of issues: it encompasses sequestration, the Bush tax cuts, the AMT, debt ceiling and the Doc Fix).

If you’re a taxpayer, the stakes are clear: no deal means tax hikes on 90 percent of Americans, starting in January. In Monday’s Inquirer I also wrote about the potential impact on local businesses and non-profits who are waiting out the uncertainty: a Burlington County, N.J. business that makes small lights for outdoors enthusiasts and the military (which could be impacted by defense cuts) and a Philly AIDS-prevention organization that could face budget cuts from reductions in domestic spending.

But what’s causing all this concern? Here’s a quick rundown:

What is the fiscal cliff?
In plain English, it’s a combination of a slew of fiscal policies all set to hit at the same time, Jan. 1. That includes some major tax hikes, smaller tax increases, deep spending cuts and a few targeted cuts. Taken all together, it would add up to a roughly $500 billion hit on the economy if all of these policies were allowed to stay in effect through 2013. (Some estimates are even higher, though it depends on how you count certain policies; whatever the specific amount, the point is there’s a lot of money in question). The country will also soon have to increase its debt ceiling – the amount the federal government is allowed to borrow – and while that deadline won't hit on the same date, it’s close enough that the fight on debt will probably also be wrapped up into these negotiations.

Taken alone, any of these issues would be a big deal. Taken together, they have the potential to roughly, abruptly jolt the fragile economy back into trouble.

What impact would it have?
The tax hikes are pretty easy to measure: nearly 90 percent of Americans would see their taxes rise, by an average of $3,500 if nothing is done to avert the cliff, according to the nonpartisan Tax Policy Center. (Of course, both parties say they want to avoid tax hikes of the vast majority of Americans – more on that below).

Economically, the combination of people having less to spend and government cutting back as well would to put the economy back into a recession, according to an analysis from the Congressional Budget Office. Unemployment would go back up to around 9 percent late in 2013, the CBO predicted in August.

Now, how quickly all this bad stuff would happen -- right away, over the course of months -- has become subject to debate (more on that below as well). But everyone agrees that if there’s no solution, 2013 looks ugly.

On the flip side, the deficit would drop sharply – to $641 billion, down from more than $1 trillion this year – but even people who want to get spending back in line with revenues see this drop as too steep and abrupt (hence the name “cliff.”)

What taxes are included?
The big ones are the Bush tax cuts approved in 2001 and 2003 and later extended in a deal between Obama and Republicans in Congress. The tax increases that would affect most Americans come from the end of Bush-era tax rates, which are scheduled to expire at year’s end and jump back to the levels they were at under Bill Clinton. Obama and House Republicans both want to keep the rates at their current levels for couples earning less than $250,000 (and individuals making under $200k). The debate is over what to do for the 2 percent making $250,000 and up (again, $200,000 for individuals). Obama campaigned on raising those rates; Republicans want to keep them at their current levels, or even lower them if they can make up for the revenue by eliminating deductions and making the tax code simpler.

A 2 percent payroll tax cut is also set to expire, costing workers $115 billion in 2013, according to the Tax Policy Center. This would be the second largest tax hike if we go over the cliff – and it appears likely to happen. Neither Democrats nor Republicans have made much noise about further extending this tax break.

Dividend and capital gains tax rates are also expected to go up for high income individuals – due to Bush-era rates also set to expire. This accounts for a relatively small piece of the pie, $8 billion according to the Tax Policy Center, and mostly affects the wealthy. Some Republicans, however, including PA Sen. Pat Toomey, say letting these rates increase will be very damaging for businesses.

Another big tax issue is the Alternative Minimum Tax, which was created long ago to make sure the wealthy pay a certain share of their income in taxes. Only the formula hasn’t kept up with the times, so Congress has to regularly override its own law to prevent the AMT from jacking up taxes on middle class families. (In Washington, this is part of the regular process).

If Congress fails to fix the AMT for the coming year, an extra 26 million filers are expected to pay it. (Though they have never let this happen).

The other big piece is a package of targeted deductions and tax credits for things like research and development that are also set to expire. They’d cost businesses and others around $80 billion.

What about spending cuts?
Here’s where we get to another of those DC terms that mean so much here and nothing else to most normal human beings: the sequester, or sequestration. That’s the term for $1.2 trillion in automatic spending cuts set to hit over the next decade, starting with $110 billion next year.

Quick explainer-within-an-explainer: when Obama and Congress raised the debt ceiling in 2011 they agreed to find a way to reduce the deficit by $1.2 trillion. Of course, in grand DC tradition they didn’t actually say how they would accomplish this. Instead it was left to a committee, but with tough penalties that were supposed to prompt a deal: cuts to defense (Republican pain) and domestic programs (Democratic pain). You can guess what happened next: there was still no deal, and now the penalties that were never supposed to happen are on the verge of happening – unless the two parties can reach a deal given a second try. If not, $55 billion will come out of each of defense and domestic programs next year. (The full effect, though, will be felt over several years, not all at once, but similar cuts will follow).

Even people who want to see a smaller federal budget are wary of these cuts, because they will hit across-the-board, targeting programs whether or not they are efficient or inefficient, beneficial or not.

At the same time, long-term unemployment benefits will run out unless they are extended – taking more money out of some Americans’ pockets and, presumably, the economy. Benefits would be cut by around $34 billion, according to the CBO.

Lastly there’s the “Doc Fix” or “Sustainable Growth Rate” or “SGR,” one of those running dramas, like the AMT. The law was meant to keep Medicare payments from growing too quickly, but once cuts were required, Congress started overriding the reductions (stop me if you’ve heard this before). Doctors are due for a 27 percent cut in Medicare payments next year – a $10 billion hit, unless another fix is agreed to.

What’s holding up a deal?
No one wants to see all of these things happen. At best, they want some of them but not others, and they want it all to happen more gradually, so as not to be such a shock to the economic system.

The AMT and Doc Fix are things both parties regularly agree to deal with, but they’re relatively small pieces of the picture here. Both parties also agree on avoiding income tax hikes on people earning $250,000 and below. (Not so, notably, on the payroll tax).

The big fight comes down to tax rates on incomes above that mark and on spending cuts involving Medicare, Social Security and Medicaid. Start with the tax rates, which are the big topic of discussion at the moment.

Obama campaigned on letting the Bush tax cuts expire above the $250k threshold – which would raise top rates from 35 percent to 39.6 percent. He won, he figures, so he should get his way.

Republicans say they held the House, so taxes shouldn’t rise, but they have signaled a willingness to increase tax revenue by eliminating deductions/loopholes and simplifying the tax code. (They’re called ‘deductions’ when they’re popular, ‘loopholes’ when they’re not). Obama says the math doesn’t add up by relying only on deductions. He’s sticking to letting those Bush cuts expire at the high end of the income scale.

Obama and Republicans, though, have been careful to leave themselves room to maneuver in their public statements. Maybe Obama eventually agrees with the GOP and uses only deduction changes to raise revenue. Maybe they raise the rates but not quite to the level they were at in the past. Those are just two possibilities.

Next comes spending – the GOP is demanding cuts to Medicare, Social Security and Medicaid, they say to make the programs more sustainable in the long run and get ahold of the costs of some of the biggest expenses really driving the federal budget. Here’s where some Democrats are likely dig in, just as some Republicans are likely to draw a red line on taxes.

The challenge will be for the two sides to give enough ground that they each A)get what they think is necessary B)make a meaningful dent in the deficit and C)can get enough votes that the hard-liners in each party don’t shoot down a potential bargain.

What are the likely outcomes?
UPDATE: I originally wrote about three scenarios, but left out a very real fourth option. It's now included below.

There are essentially four things that can happen between now and the end of the year (with a million variations on each of the three).

The biggest surprise would be a “grand bargain” now that overhauls the tax code, replaces the big cuts with more targeted reductions, increases tax revenue and sets the federal budget on a newly sustainable path all before we sit down to watch college Bowl games Jan. 1. This kind of generational deal may be in the offing eventually – and could be critical to Obama’s legacy – but it seems it will take more time than lawmakers have left in 2012.

Option 2 is that the two sides reach the broad outline of a big deal, laying the groundwork for a sweeping agreement next year while immediately adding some tax revenue and some budget cuts. The final pieces would come together early next year, after Obama’s inauguration. A new deadline trigger (Sequestration II!) would (theoretically) make them stick to their deal. At the moment, this outcome seems most likely. No one wants to see the impacts of the cliff, but there doesn’t seem to be enough time to work out the full details of a massive deal before New Year’s day.

(UPDATED OPTION) If there's no deal at all, Congress could do what Congress does best: punt the entire big decision down the line. Yes, the sequester was supposed to be a big, bad penalty that prompted action. But rather than face the consequences of their inaction, Congress could simply write a new law maintaining the status quo -- same tax rates, same spending, same tax code, no harm to the economy and no progress on balancing the budget -- and move the penalties, say, six or 12 months down the road. This time, they'd pinky swear that they'LL really really get serious about solving these problems by the new deadline.

Lastly, the two sides could dig in and we could just go over the cliff, bad consequences and all. For Democrats, there may be some political advantages to this: for one, taxes would automatically increase on everyone, so once we're over the cliff, Obama could argue for passing tax cuts for the middle class -- giving most Americans some relief -- and leave Republicans to either join him or let everyone feel the economic pain while the GOP holds out for the top 2 percent. That would bring a lot of pressure on Republicans, and might give them some political cover if they went along with the President (after all, taxes will already have risen, regardless of their votes; now they’d be voting for a tax cut, not an increase on the wealthy).

But what about the potential recession and tax hikes? Some argue that the “cliff” is more like a “slope” and that the pain of all these policies for just a few weeks in 2013 might not be so bad. It’s not like anyone would have to pay their full, increased tax bill all at once – though their withholdings would decrease right away. The budget cuts could maybe be papered over for a bit with left-over money from 2012 or restored once a deal was struck. Same with tax rates, which could be lowered retroactively. Maybe a few weeks of belt tightening wouldn't bring the carnage many expect. The full $500 billion impact doesn't hit Jan. 1 -- it would be felt over the course of 2013.

Then again, that’s taking a pretty big risk with a shaky economy, and could badly damage what recovery Obama has overseen. No one knows how the markets would react to the uncertainty of budget cuts and tax hikes that could go on for … who knows? Weeks? Months? All of 2013? If there’s no deal now, who’s to say one gets done in January?

It would also send a bad message that our leaders were unable to come to a compromise even when facing all sorts of penalties and reasons to reach a deal.

We’ll find out in the coming weeks if they go that far.