Lame Duck for Holiday Season

With the election over, it's time for a lame duck session of Congress to avert the fiscal cliff, while negotiating new financial pressures from Hurricane Sandy and sexual scandal by the CIA director.Congress is back in town to stare at the same tax, debt and jobs issues as before the election — with the same fiscal cliff looming in a mere 48 days.

In addition to the impact of the 2012 election results, the lame duck congressional session has experienced the financial reverberations of cleaning up after Hurricane Sandy and the surprising sexual revelations that forced the resignation of popular CIA Director David Petraeus.

Pending fiscal mayhem mixed with a DC political drama combining sex, power, cover-ups, imprudent emails and possible national security lapses provides the perfect punctuation mark for what has been a tortuous and seemingly endless political season.

So while Republicans pondered how to reinvent themselves and Democrats openly negotiated on how to negotiate, the Congressional Budget Office renewed its warning of a potential recession unless Congress reaches a bipartisan agreement to avert sharp tax increases and automatic, across-the-board spending cuts. CBO says the U.S gross domestic product in 2013 could drop by 0.5 percent and unemployment rise to more than 9 percent.

Members from both major political parties appear eager to resolve the problem, but at the moment are jockeying for position. House Speaker John Boehner told his chastened GOP caucus some compromise on revenue will be necessary. Democratic Budget Committee leaders signaled an interest in the income tax deduction cap proposed by GOP presidential candidate Mitt Romney, which echoed an idea earlier surfaced by President Obama.

There are two possible outcomes we see as most likely at this point:

Scenario 1: With 48 days, there isn't much time to work out a comprehensive agreement. However, there is enough time to work out a framework with binding caps and timelines, similar to the process outlined in the August 2011 budget agreement. This would involve passing a 6-month extension of all the tax and sequestration cuts set for January 1. The extension would be tied to a rigid congressional process requiring buy-in from both sides. This process again will have consequences for failure similar to the sequestration. Basically, this is a "kick the can down the road" scenario, but the end of the road is in sight.

Scenario 2: We go over the fiscal cliff. There is about a 30 percent chance the two parties just can't come to an agreement and we dive head first off the budgetary cliff hand in hand with both parties holding their noses. The consequences of such action are not entirely clear, but some Democrats and Republicans feel this may be the best way to force a bipartisan agreement in the early months of 2013. It's risky, but there is some merit to this option.

Here is what the Congress and the President must solve to avoid a year-end economic calamity:

The Expiration of the 2001/2003/2010 Tax Cuts
On December 31, the set of tax cuts enacted in 2001 and built upon in 2003 and 2010 will expire. As a result, the top rate will rise from 35 percent to 39.6 percent and other rates will rise in kind. The 10 percent bracket will disappear. The child tax credit will be cut in half and no longer be refundable. The estate tax will return to the 2001 parameters of a $1 million exemption and a 55 percent top rate. Capital gains will be taxed at a top rate of 20 percent and dividends will be taxed as ordinary income. Marriage penalties will increase and various tax benefits for education, retirement savings, and low-income individuals will disappear.

The End of AMT Patches
Congress generally "patches" the Alternative Minimum Tax (AMT) every year to keep pace with inflation. As a result, more than 4 million tax returns currently pay the AMT. If a new patch is not enacted retroactively for 2012, that number will increase to more than 30 million and could exceed 40 million by the end of the decade.

The End of Jobs Measures
In February, the President signed an extension of a 2 percent payroll tax holiday and extended unemployment benefits through year's end. Under current law, both will disappear at the end of the year, causing employee payroll taxes to increase from 4.2 percent to 6.2 percent and reducing the number of weeks individuals can collect unemployment insurance.

The End of Doc Fixes
The Sustainable Growth Rate formula calls for a substantial reduction in Medicare payments to physicians — a reduction lawmakers have deferred through continued "doc fixes" since the early 2000s. At the end of the year, the current doc fix will end, leading to a nearly 30 percent immediate reduction in Medicare physician payments.

The Activation of the Sequester
Beginning on January 1, an across-the-board $1.2 trillion spending sequester over 10 years will go into effect. The sequester will immediately cut defense spending across the board by about 10 percent and non-defense discretionary spending by about 8 percent. It will reduce Medicare provider payments by 2 percent. In total, this will result in an immediate $110 billion single-year reduction in budget authority.

The Expiration of Various "Tax Extenders"
Various normal "extenders," such as the research and experimentation tax credit and the state and local sales tax deduction, expired at the end of 2011. Some of these extenders are likely to be reinstated retroactively at the end of this year, but will disappear under current law.

Reaching the Debt Ceiling
The debt ceiling agreement reached last summer is likely to allow continued borrowing through early 2013. The debt ceiling will need to be increased again in order to avoid a potential default. It's possible the debt ceiling increase could be included in a broader deficit reduction package.