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Director of the Congressional Budget Office Douglas Elmendorf. GettyThe nonpartisan Congressional Budget Office is warning that if $607 billion in tax increases and spending cuts all hit as scheduled -- roughly the beginning of next year -- the U.S. will likely go into recession in 2013.

This is the "fiscal cliff" you may have heard about. But while economists, the Federal Reserve, and members of Congress have been warning about its approach for some time, the CBO's report is the first detailed analysis of its potential effects.

A Recipe for Recession

All of the following are scheduled to occur around the turn of the year, and together make up the so-called fiscal cliff:

  1. The expiration of the Bush-era tax cuts, including a 3% to 5% upward income-tax adjustment and a 5% increase in the capital-gains tax.
  2. A return of the alternative minimum tax, which could affect those with yearly incomes as low as $30,000.
  3. A 2% payroll tax increase, which had temporarily been cut for 2011 and 2012.
  4. $1.2 trillion in automatic budget cuts, because the president and Congress failed to pass a deficit-cutting package in the wake of last summer's debt-ceiling debate.

While we're on the subject, the debt ceiling is due to be raised again in early 2013, prompting fears of another credit-rating damaging battle between the White House and Congress.

Each of these events happening in turn would likely have some negative impact on our struggling economy. But it's all of them happening at basically the same time that has the CBO so concerned.

Doom and Gloom? Yes and No

According to the CBO, if nothing is done to stop or alleviate these "fiscal restraints," the economy is "expected to contract by an annual rate of 1.3% in the first half of next year." But the silver lining in taking these economic hits all at once is a reduction in the federal deficit of 5.1% in calendar years 2012 and 2013, and a reduction in the federal budget of $560 billion for fiscal years 2012 and 2013.

Conversely, if Congress and the president agree to extend all the tax cuts and not cut any spending, the U.S. economy could grow at a robust 4.4% next year. To do so, however, would come with continued growth of the national debt. The CBO calls this "unsustainable" over the long term, adding that "policy changes would be required at some point."



We Can Do This the Hard Way, or the Hard Way

The public debt is currently around 70% of GDP -- getting up into eurozone crisis levels, but without a hint yet of eurozone-level panic. For that, we can thank the fact that the U.S. dollar is still the world's reserve currency and Treasuries are still seen as the ultimate safe haven, which keeps yields low. This has shielded us from the ruthless vagaries of the sovereign bond market, which is currently giving the eurozone such a hard time.

Right now, Republicans want to renew the Bush-era tax cuts. Democrats want to let them expire, except for those with annual salaries of less than $250,000. Neither side wants the $1.2 trillion in automatic budget cuts to hit, but Republicans especially -- as a well-funded military is part of their political bread and butter.

Likewise, the Democratic party probably doesn't want a return of the alternative minimum tax, because the less-well-off, which the tax would hit hardest, have always been a greater part of its constituency. The payroll tax cut was championed by President Obama, but the rationale for it -- an economy in recession -- is gone.

And neither side ought to want another high-stakes, high-profile debt-ceiling debate. Last summer, it cost the country its coveted AAA credit rating. But depending on who's sitting in the oval office come 2013 and what parties come out ahead in the House and Senate, it may not even be an issue.


So the U.S. can take its licks now or later, but it will have to take them at some point along the way. The most sane and least painful way to do it would be to find middle ground between the two policy extremes outlined above -- one that would allow for a slower winding down of debt that keeps growth at a reasonable level, something the CBO also suggests.

The point is, there's clearly room in the coming fiscal-cliff showdown for maneuver, negotiation, and face-saving on both sides. Let's hope it's taken advantage of.


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