How Washington Can Turn a Tax Increase into a Tax Cut by Leaping Off the Fiscal Cliff

In the strange alchemy of Washington, Congress can magically turn a tax increase into a tax cut.  And to make it happen, all it has to do is…nothing.     

Yesterday, Senator Patty Murray (D-WA) told an audience at the Brookings Institution that she would prefer to let the government tumble over the fiscal cliff at the end of the year rather than accept a deficit reduction plan built on spending cuts only. Murray—a senior Senate Democrat who speaks for her party’s leadership — argued it would be better to allow the 2001/2003/2010 tax cuts to expire and let automatic spending increases kick in as scheduled rather than extend those tax cuts for the highest income households.     

No doubt, much of this is political posturing. With Republicans increasingly worried about the impact of those end-of-the year reductions in defense spending, and with the GOP’s presumptive presidential nominee Mitt Romney suffering through a rough patch, Democrats such as Murray may feel emboldened to raise the fiscal threat level to DEFCON 2.

But this is also about the arcana of budget baselines–where by waiting a few minutes on New Year’s Eve, Congress can entirely reframe the fiscal debate.

How? Let’s take a simple example. On Dec. 31, 2012 the top tax rate will be 35 percent. On Jan. 1, 2013, it will rise to 39.6 percent.

Say you are a politician who favors a top tax rate of, say, 37 percent. If Congress extends the 2012 rules and keeps the top rate at 35 percent, you would be raising taxes—a tough sell. But if Congress lets rates rise to 39.6 percent, your 37 percent rate looks like a tax cut.

The same thing happens to the dozens of mostly business tax subsidies that are expiring this year. Once they are extended for another year, any attempt to scale them back looks like a tax increase. But if they are allowed to expire, Congress can restore half of them and call it a tax cut. See, it is magic.

These steps would still increase the official Congressional Budget Office baseline deficit, since it already assumes the tax cuts expire. But the CBO deficit falls from $1 trillion in 2012 to about $585 billion in 2013. That gives you plenty of room to add back some tax cuts and still say you’ve reduced the deficit by hundreds of billions of dollars compared to 2012.

Democrats hope this strategy will change the conversation from the unproductive squabble over the Bush-era tax cuts to a serious talk about what a new revenue code should look like. It might insulate Democrats– and more importantly Republicans– from charges that they are raising taxes.

Besides, supporters of this strategy say, the whole fiscal cliff metaphor is all wrong. It is more of a fiscal slope, where spending cuts gradually bite and taxes slowly rise. In reality, they insist, any crisis would last only a month or two since the fear of recession would finally drive Congress to write a tax code that is fair, economically efficient, and sufficient to pay the government’s bills. Murray’s speech may have been part of an effort to adjust market expectations to reflect that hope.  

Still, this is a very risky game.

Inaction would wipe the 2001/2203/2010 tax cuts off the books, restore the Clinton-era estate tax, allow the Alternative Minimum Tax to hit 21 million taxpayers, and end the 2011 payroll tax cut. In fiscal 2013 alone, it would pull nearly $400 billion out of the economy. The psychological impact of a fiscal train-wreck on already-nervous businesses, consumers, and markets might multiply the risk. CBO figures these and other scheduled tax increases plus the automatic spending cuts would throw the U.S. back into recession.

Plus, it would be a tax administration nightmare. One example: Since the AMT fix has already expired, how would the tax be treated for Tax Year 2012 returns? Early filers would have to amend returns. It would be a mess.

For all that, deficit hawks and tax reformers see an opportunity to reframe the budget and tax debate—potentially a good thing. But it is a very dangerous way to get there.