Consequences of Congressional Action and Inaction, and the Expected Role of the Lame Duck Session

It has been given different names: "fiscal cliff," "taxmageddon," all of which sound like the name of bad screenplays written by a tax lawyer or accountant.

However, the pending expiration of tax and spending provisions, implementation of across-the-board spending cuts, and need to raise the federal debt limit are real and will come to a head in the United States within the next several months.

This alert summarizes the possible consequences of these issues, especially the effect of their confluence, and analyzes possible outcomes.

What is Looming

Expiration of Lower Tax Rates and Other Provisions Originally Enacted in 2001, 2003, and 2009

These are the tax provisions originally enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "2001 Act"), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the "2003 Act"), and the American Recovery and Reinvestment Act of 2009 (the "2009 Act") that were extended in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "2010 Act"). The most prominent provisions are the current income, dividend, and capital gains tax rates (the so-called "Bush tax cuts"), but they also include a variety of credits and incentives.

Sequestration Beginning in January 2013

Due to failure of the Joint Select Committee on Deficit Reduction (the so-called "Super Committee") to agree on a budget plan, across-the-board spending cuts (a "sequester") will begin in January 2013.

Revenue Raisers Enacted as Part of Health Care Reform

Several revenue-raising provisions included in the health care reform package had delayed effective dates. Provisions that become effective in 2013 include the 3.8% Medicare tax on wages and investment income and the excise tax on medical device makers.

Unemployment Insurance

The 2012 Act extended temporary emergency unemployment benefits through 2012.

Medicare Payment Rates for Physicians

The 2012 Act extended the temporary so-called "doc fix" through 2012.

Temporary Payroll Tax Reduction

Originally enacted as part of the 2010 Act, the Middle Class Tax Relief and Job Creation Act of 2012 extended the 2% point reduction in the payroll tax through 2012.

Retroactive Extension of Expired Provisions

These include the so-called AMT patch which has greatly limited the number of taxpayers subject to the alternative minimum tax or AMT. The provisions also include the research and experimentation tax credit, the production tax credit for renewable energy, and other temporary tax provisions, often referred to as the "extenders," which expired at the end of 2011 but which have historically been extended, including retroactively when allowed to lapse. Also in this category is 100% expensing for business equipment temporarily enacted in the 2010 Act.

Reversion to Pre-2001 Act Estate and Gift Tax Rules

Current estate and gift tax rules, included in the 2010 Act, expire at the end of 2012.

Other Items Likely to be in the Mix

1. Debt limit increase. Treasury Secretary Geithner has stated that the debt limit will probably not need to be raised before the election, but it is not clear how soon after the election it will need to be raised. How quickly the federal government runs out of borrowing authority will depend in part on how all of the pending provisions described above are handled. Recall that last year's debt limit increase was the catalyst for the legislation that ultimately resulted in the pending sequester.
2. Budgets for various federal agencies. If Congress and President Obama cannot agree on spending levels for the 2013 fiscal year budget, they will have to keep extending the operation of the federal government through continuing resolutions until they (or their successors) can reach agreement.
3. Unexpected events. We do not know what they are, but we know they will inevitably arise and that they will take up time and resources that Congress and the President thought they could devote to the items described above. For example, if the US Supreme Court invalidates all or a portion of the health care reform legislation, health care reform and its associated issues will once again consume the time and attention of President Obama and the Congress. Similarly, any one of a long list of countries could trigger a financial or national security crisis.

Current Plan

Right now, President Obama and Republicans and Democrats in Congress appear to be in agreement on how (not) to address these looming issues. The implicit agreement is to insist on a resolution that is completely on your terms, schedule a few votes to show that you tried, and postpone hard decisions until after the election in the lame duck session.

This view results more from pessimism regarding the current state of affairs than optimism that resolution of these issues will be easier after the election. Congress and President Obama are facing these expiring tax and spending issues because they have not been able to enact long-term resolutions when the issues have arisen in the past. Sequestration is kicking in because neither Congress nor the Super Committee could agree on specific spending cuts. Procrastination is the most attractive option because any resolution will be controversial and engender significant opposition and criticism from across the political spectrum. During the election campaign both Democrats and Republicans want to emphasize their differences on tax and spending policy. Partisans view reaching a common agreement before the election as blurring distinctions that would otherwise be emphasized.

In light of these political desires and concerns, the following conclusions may be drawn: 

To the Extent Possible, Congress and President Obama will Delay Any Unpopular Decisions until after the Election

This includes those issues where there is no good resolution (e.g., the sequester) and those where compromise is necessary but any reasonable compromise will anger one or both parties' base (e.g., taxes).

Significant Groundwork Must be Laid before the Election

Even under ideal circumstances in the lame duck session, there is simply too much to resolve and too little time to do it if decisions are being made from scratch. Alternatives have to be designed ahead of time, and individuals and companies need to weigh in now. In light of the length of the to-do list, lower priority items will be pushed aside in the lame duck session. Accordingly, proponents of time-sensitive but less momentous measures should realize that they need to deal with those matters before the election, lest they be shunted aside until much later in 2013 (which will be too late for things like retroactive extension of the "extenders" that expired at the end of 2011).

How Specific Matters are Resolved Will Depend on the Outcome of the 2012 Election

This is true not just for substantive outcomes (i.e., for ideologically-charged issues, the party that comes out of the election with a stronger hand, or a perceived mandate, will likely get its way) but also procedurally. If there is a question as to who was elected President (as in 2000) or who controls the Senate or the House, negotiations will be delayed until the position of strength of bargainers is clearer. This will also arise on an individual level if particular members are defeated and in a position of responsibility during the lame duck session but will not be in such a position later in January.

It Will Take Some Sort of Crisis to Cause Congress and President Obama to Deal with These Issues Prior to the Election

For that reason, predicting how or when Congress will deal with these looming issues is difficult since it requires predicting whether a crisis (and, if so, which crisis) will occur and when. It will presumably have to be a real crisis and not just a threatened one: judging by the continued unpopularity of the so-called bailouts in 2008, members of Congress receive no credit for saving the public from a future (as opposed to immediate) crisis. An angry and distrustful public may lead Congress and the President to avoid pre-emptive action and to wait until a crisis actually occurs and there is clearly no other choice than to act. In that case, the consequences of waiting until the last minute will mean that options are much more limited and actions needed to be taken are much more radical.

Possible Outcomes

Congress and President Obama Do Nothing in 2012

1. Likely behavioral changes in response to higher taxes: Individual investors, fearful of paying higher capital gains tax rates in 2013, accelerate sales of assets to take advantage of expiring tax rates (and to beat the effective date of the 3.8% Medicare tax on investment income). The prices of investment assets that are disproportionately owned by individuals (whether directly or through pass-through entities), such as real estate, will be under pressure as the number of sellers increase at the end of the year. Individuals, especially high-income individuals, seek to accelerate recognition of income into 2012 while income tax rates are lower. More generally, however, taxpayers will restrain spending in anticipation of higher tax rates and businesses will defer hiring and investment in anticipation of an economic slowdown in 2013. See the Congressional Budget Office's "Economic Effects of Reducing the Fiscal Restraint that is Scheduled to Occur in 2013" (May 2012) (the "May CBO Report"). Beginning in January, take-home pay drops as employers withhold more tax.
2. Likely behavioral changes in response to sequester: Scheduled reduction in spending causes companies with significant government contracts to reduce employment and investment. Federal agencies are expected to deal with reduced budgets by reducing expenditures in the manner they can most easily do so, which in most cases will be payments to private sector entities. There are already press reports that defense-related companies are planning for plant closures and mass layoffs. The Aerospace Industries Association has asserted that more than 1 million jobs would be lost (directly and indirectly) as a result of the defense cuts mandated by the sequester. Note that if a plant closing or mass layoff triggered by the sequester is subject to the Worker Adjustment and Retraining Notification ("WARN") Act, the company undertaking the plant closing or mass layoff must send a notice at least 60 days prior to the event. Since January 2, 2013, is 57 days before the election, WARN Act notices are likely to be sent before the election.
3. Debt limit: Possible reaching of the debt limit, without any clear indication of how Congress and the President will raise it, may cause interest rates to rise and result in additional credit downgrades of the US government. The interaction with European sovereign debt problems could prompt a global financial crisis. However, if Congress and the President fail to extend the expiring tax and spending provisions, and allow the sequestration to take effect, the debt limit will not be hit until later in the year, compared to the acceleration in reaching the debt limit that would occur if expiring tax and spending provisions are extended without offset and/or sequestration is repealed or delayed.
4. Overall economic effect: According to the May CBO Report, permitting current expirations and the sequester to take place would reduce the federal budget deficit by 5.1% of GDP between calendar years 2012 and 2013. Although that may be good in the long-run, the short-term consequences would be severe. Because this would be the equivalent of withdrawing that amount of stimulus in 2013, it would cause real GDP growth to drop to 0.5% in calendar year 2013 (reflecting a contraction at the annual rate of 1.3% in the first half of the year and an expansion at the annual rate of 2.3% in the second half of the year). The May CBO Report also assumes that anticipatory actions of individuals and companies will reduce real GDP growth in the second half of 2012 by about 0.5% at an annual rate. This does not take into account any other shocks to the economy that occur.
5. Current likelihood: 20%. This is a likely outcome in a "wave" election (i.e., one party sweeps the House, Senate, and Presidency) if the losing party does not completely cave in the lame duck session. If one party wins control of both Houses and the Presidency, it will want to wait and deal with resolution in 2013 when it has more power. In that case, the question is whether the "losing" party will agree to a short-term extension to give the "winning" party time to address. If not, there will be gridlock in the lame duck session. Tax provisions will expire and sequestration will kick in until the "winning" party has an opportunity to address.

Congress and President Obama Postpone Expirations and the Sequester

1. Likely behavioral changes. Because this would continue current tax and spending policies, there should be no behavioral changes in response to extensions and delay in the sequester, provided the extensions and delay in the sequester are sufficiently long that individuals and companies can rely on them.
2. Debt limit: Assuming that extensions and delay in the sequester are not offset, this action would accelerate the reaching of the debt limit. Accordingly, Congress and President Obama will likely have to deal with an increase in the debt limit simultaneously with the extensions and delay in the sequester.
3. Overall economic effect: Continuing current law would prevent the 5.1% reduction (as a percentage of GDP) that would otherwise occur in the federal budget deficit. Accordingly, CBO calculates that real GDP growth in calendar year 2013 would be 4.4%. Employment would be approximately 2 million higher. See the May CBO Report. Although this scenario would result in moderate economic and employment growth in 2013 (rather than a recession), it would have severe long-term consequences as debt continues to grow in an unsustainable manner much faster than the economy.
4. Current likelihood: 30% one year or less; 10% more than one year. This is one of two likely outcomes in a "status quo" election (i.e., House stays under Republican control, Senate stays under Democratic control (and under 60 votes), and President Obama is reelected). It is difficult to see Republicans and Democrats backing down from their positions if each thinks the public ratified its view in the election. In that case, a possible resolution would be temporary extension of tax cuts and temporary relief of sequestration, possibly tied to some agreement to resolve differences (e.g., taxation of high-income individuals) through tax reform.

Congress and the President Partially Extend Some Tax and Spending Measures

The specific details would depend on what happens in the election (or, if caused by a pre-election crisis, the aspects of the crisis). CBO laid out one possible middle-ground scenario, however, in what it calls its "alternative fiscal scenario." That assumes that "all expiring tax provisions (other than the payroll tax reduction), including those that expired at the end of December 2011, are . . . extended; that the alternative minimum tax is indexed for inflation after 2011 (starting at the 2011 exemption amount); that Medicare's payment rates for physicians' services are held constant at their current level; and that the automatic enforcement procedures specified by the Budget Control Act of 2011 do not take effect." Certain expiring provisions, such as the temporary payroll tax reduction and emergency unemployment benefits, are permitted to expire. This would likely be combined with future revenue increases or spending cuts intended to offset the otherwise negative long-term budget impact of this short-term reprieve in tax increases and spending reductions.

1. Likely behavioral changes. Because this would continue most of the current tax and spending policies, behavioral changes in response to extensions and delay in the sequester should be small, provided the extensions and delay in the sequester are sufficiently long that individuals and companies can rely on them.
2. Debt limit: Assuming that extensions and delay in the sequester are not offset in the short-term, this action would accelerate the reaching of the debt limit. Accordingly, Congress and President Obama will have to deal with an increase in the debt limit simultaneously with the extensions and delay in the sequester or shortly thereafter.
3. Overall economic effect: Because this would continue much of current law, CBO estimates that real GDP would grow by 2.1% in 2013. Employment would be 1.5 million higher in 2013, compared to allowing expiration of the tax and spending provisions and repeal of the sequester. See May CBO Report. As with the full-postponement option, this scenario would have negative long-term consequences unless it was offset by future spending reductions or revenue increases. Indeed, its political palatability will likely depend on whether it can be offset by such changes and therefore be described as deficit-neutral or as long-term deficit reduction.
4. Current likelihood: 40%, includes all variations. This is the most likely scenario for two reasons. First, even if Democrats and Republicans cannot agree on extension of all of the provisions, they can agree on most of them. Accordingly, absent a complete breakdown in negotiations, each side will prefer to agree to a partial extension rather than be tarred as the one that caused a recession because it insisted on a specific provision. Second, to the extent that a partial extension is combined with long-term fiscal tightening, this is the most attractive option since it allows one to support increasing economic growth and employment in the short-term and fiscal responsibility in the long-term. The vaguer the fiscal responsibility in the future, the more popular this option will be. The only reason the odds are not higher is because if the election results in significant change (e.g., a new President is elected), the "winning" party may want to delay major decisions until the new President is in office. In that case, although Republicans may seek a short-term solution to buy time for the new President, Democrats may not be inclined to make it easier for the new President, especially since feelings will be raw so soon after the election. Similarly, if one of the Houses flips, the party that will be the new majority will be inclined to offer no better deal in the lame duck session that it would expect to obtain in 2013. So, the result in that case is likely to be gridlock, with short-term extensions and delay in the sequester only if failure to provide short-term relief would be disastrous. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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