'Fiscal cliff' deal would limit deficit reduction

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John W. Schoen , NBC News

As Congress and the White House settle in to a new round of talks over the federal budget, there are no good choices. If there were, the impasse would have been resolved a long time ago.

But as both sides vow to reach a compromise, it’s becoming clear that any bipartisan agreement will fall far short of the current law in cutting the $1.1 trillion federal deficit.

The current budget law that created the so-called “fiscal cliff” was written in a high-stakes moment in July 2011 as an impasse over raising the federal debt ceiling left the Treasury just days away from defaulting for the first time in history. The law’s architects, who well understood the dire consequences of allowing massive tax hikes and spending cuts to take effect, created the law as a club to force action after the November election.

Now that the election is over, leaders of both political parties have expressed the desire to come to an agreement and end the long deadlock.

But with the composition of Congress largely unchanged, any tax hikes and spending cuts both will likely be far smaller than what each side might want.

"The split in Congress will force both sides to bargain,” said economist Paul Ashworth of Capital Economics. “We expect the Democrats to agree to extend the Bush-era (tax cuts) for higher income earners in exchange for Republicans agreeing to put off the spending cuts."

On Sunday, Sen. Bob Corker, R-Tenn., expressed confidence that a deal could be reached, and Obama aide David Axelrod hinted at compromise on raising tax rates on the rich, a key White House priority.

House Speaker John Boehner, R-Ohio, last week opened the door to compromise on his party's commitment to not raise tax rates, saying he would support changes in the tax code that bring in more revenue.

Obama has invited congressional leaders to the White House on Friday to discuss the issue.

There had been hope that last week's election might break the longstanding political deadlock that has thwarted action. Republicans hoped to gain control of both the Senate and White House, the better to fulfill promised deep spending cuts. If Democrats had been able to gain control of both the House and Senate, they would have faced less opposition to tax hikes.

The continuing divided control in Washington means that a successful bipartisan agreement will have less to do with deficit reduction than with dodging the political backlash that would ensue if automatic spending cuts and tax hikes are allowed to take place, potentially sending the economy back into recession next year.

Unless amended, the current law ends Bush-era tax cuts, raising taxes by roughly $330 billion at a cost of about $3,500 for every household. Also on the block is the Obama administration's two-year payroll tax cut, which would cost wage earners another $95 billion. Other provisions, including the elimination of a deduction for sales tax, would raise taxes by another $65 billion.

Spending cuts in the law include a $55 billion or 9 percent cut in the defense budget next year and another $55 billion in cuts to domestic programs, including a 2 percent or $11 billion cut to Medicare providers. Long-term unemployment benefits would by cut by $26 billion.

While painful, those measures - if left in place - would only cover roughly half the annual federal budget gap.

All of which means that as the odds of meaningful deficit reduction grow slimmer as both sides move closer to a compromise.

Democrats, including President Barack Obama, have said any compromise should include higher taxes on the top earners who make more than $250,000 a year. But that would raise only about $42 billion, according to the Congressional Budget Office. That amounts to about 3 percent of the annual deficit.

Balancing the budget with spending cuts has proven even harder, largely because so much of the budget is devoted to historically “untouchable” categories like defense and direct payments to taxpayers. Social Security, Medicare and defense spending consume 60 cents of every tax dollar. Add pensions for federal workers and veterans, safety net programs like unemployment insurance and interest on the debt, and there’s roughly 20 percent of the federal budget left open to cutting.

That’s why Congress has made so little progress over the years finding ways of postponing the tax hikes and spending cuts required to bring the budget into balance.

In the short run, the cost of delay may not be so dire.

Despite the dire warnings of sudden fiscal impact, the cliff is more like a slope, as the economic impact would be felt gradually.

The average U.S. household would see a tax increase of about $68 a week, adding up to $3,500 if Congress fails to act over the full year.

On the spending side, most government agencies facing cuts have broad discretion on how they phase them in over the remainder of the fiscal year, which ends Sept. 30. If Congress and the White House don’t reach a deal by Jan.1, some agencies could decide to continue spending at current rates, with the expectation that a deal would be reached sometime next year that to pare back spending cuts – or postpone them altogether.

Congress has also bought time with the help of the Federal Reserve, which responded to the financial collapse of 2008 by slashing interest rates to record lows. Just as homeowners have saved tens of billions of dollars on lower mortgage rates, the federal government has seen its cost of borrowing fall sharply – even as the size of the debt has increased.

In fiscal 2008, the Treasury spent $451 billion in interest on roughly $10 trillion in public debt outstanding. For the fiscal year that ended Sept. 30, Uncle Sam paid just $360 billion to service debt of more than $16 trillion.

But the Federal Reserve can’t keep rates low forever. Those low rates rely heavily on investors’ belief in the safety of U.S, Treasury debt, which faces another downgrade if rating agencies decide the government has lost control of its finances. If investors stop buying U.S. bonds, borrowing costs could rise and the value of the dollar would fall.

So while some have suggested that the economic threat of fiscal cliff has been overstated, the potential financial disaster of expanding deficits is very real, according some financial analysts, including Peter Schiff, CEO of Euro Pacific Capital.

“That disaster will take the form of a dollar and/or sovereign debt crisis that will make the fiscal cliff look like an ant hill,” he said.