With hope high that TPTB will see fit not to plunge us over the cliff, we thought it useful to get some perspective on what the grand compromise might look like. Goldman's central assumption - albeit a close call - is that an agreement is found that includes a tax increase of a magnitude similar to the upper income tax cuts, though the composition might differ. Entitlement reforms also seem likely to be part of a package, particularly related to health programs. "Down-payments" in both areas seem likely, with additional deficit reduction to be enacted in 2013 as part of a two-stage process. The working deadline for an agreement appears to be December 21. While talks are ongoing, we, like Goldman, would not expect serious negotiations to begin for another couple of weeks. In the interim, headlines out of Washington are likely to be mixed, but we would expect more negative than positive news until at least mid-December.
Via Goldman Sachs: The Fiscal Cliff: Q&A on the Shape of a Year-End Agreement
Q: Will an agreement be reached by the end of the year to avert most of the fiscal restraint now scheduled for January 2013?
A: Our central assumption is that an agreement will be reached prior to year-end, but it remains a close call and there are several obstacles that must be overcome first. The most important is to find some way past the disagreement on the upper-income tax cuts. The President insists that he will sign no further extensions into law, while congressional Republicans oppose any increase in tax rates, which would occur if the tax cuts were allowed to lapse. There is more common ground on the concept of raising revenue. However, congressional Republicans have stipulated that revenue increases should come only with significant reforms to entitlement programs, and they prefer to raise revenue through tax reform, while congressional Democrats and the Obama Administration prefer to raise rates. While most of the media coverage of the fiscal cliff is focused on whether an agreement can be reached on the tax component of a package, overcoming disagreements on how much to reduce entitlement spending is a sizeable challenge as well.
Q: If a deal is reached, what might it look like?
A: Our best guess is a tax increase similar in size to the upper-income tax cuts and a "downpayment" on entitlement reform. Allowing tax rates to rise and other policies to expire for incomes over $250,000 would increase revenues by slightly more than $800 billion over ten years starting in 2013. The White House has opposed a compromise that does not involve an increase in tax rates, but this does not preclude an agreement that relies on a limitation of tax preferences for a good part of the revenue increase, along with increased rates to make up the remainder. As we outlined last week, some combination of rate increases and limitation of tax preferences seems to be the most obvious path to an agreement at year-end.
On the spending side, it is even less clear what types of policies might be enacted at year-end, but some changes to Medicare and Medicaid appear likely to be included, along with perhaps some of the miscellaneous cuts--federal employee retirement benefits, agricultural subsidies, postal reform, among others--that were discussed in last year's debt limit negotiations but never enacted. Congressional Republicans have emphasized the need for structural changes to health entitlements as part of the package, rather than cuts in payments to health care providers and other methods Congress typically relies on to find budgetary savings.
Q: Will it be a single package or two-stage process?
A: The focus continues to be on a two-stage process. Since last year's debt limit discussions, negotiations have tended to focus primarily on a two-step process, in which an initial round of tax increases and spending cuts are enacted immediately, and targets are agreed to for an additional round of spending and tax reforms to be detailed at a later date. The current debate seems headed in this direction as well. The President is seeking $1.6 trillion in new revenues, but it seems very unlikely that the year-end deal would actually enact such a large increase. Instead, it is possible that if policies are enacted at year-end that raise an amount similar to the upper income tax cuts (i.e., around $800bn), any additional revenue that is agreed upon could be targeted as part of a tax reform effort in 2013.
Entitlement reforms are even more likely to be dealt with in a two-stage process. Some of the changes that might be made to entitlement programs--particularly Medicare and Medicaid--get into more complex areas of health policy that would be difficult to sort out in the next few weeks. More than most other areas, this is a segment of the budget where it is difficult for political leaders to hammer out details at the last minute, and instead where more thorough consideration in the congressional committees with expertise on the programs is likely to be necessary.
That said, there is no reason that all of the substantial reforms that might be made to the tax code and entitlement programs would need to wait to 2013. Most of these changes have been debated for years, and in a few cases, for decades. And while some of these reforms are indeed complex, not all are. For example, an across-the-board limitation on tax preferences or a gradual increase in the Medicare eligibility age would be relatively simple to write into legislation, if there is political will to do so.
Q: How much deficit reduction might an agreement involve?
A: Probably between $1 trillion and $2 trillion over ten years. The agreement that may be reached at year-end should be considered in the context of last year's debt limit agreement, the Budget Control Act of 2011. That law cut projected spending by $2.1 trillion over ten years by capping congressional appropriations and imposing the automatic spending cuts under the "sequester" set to take effect January 2013. We assume that the spending caps will remain in place and that, while sequester will be mostly reversed for 2013, a comparable level of savings will be phased in over the few years that follow.
If an agreement is reached by year-end, it seems likely to target at least $1 trillion over ten years in net deficit reduction, and might reach as high as $2 trillion if lawmakers include aggressive targets for entitlement reform and tax reform in a two-stage framework. That level of deficit reduction, if realized, would likely be sufficient to stabilize the debt/GDP ratio over the next several years, though to do so would involve a pace of fiscal restraint that would weigh on growth for the next few years as that deficit reduction took hold.
Q: Will it address the debt limit?
A: It seems likely. The debt limit will need to be raised by February or March 2013, if not before. Policymakers have been urged by business leaders, rating agencies, and others to avoid another messy debt limit debate, and could include a debt limit increase in the year-end deal. To the extent that the agreement involves immediate policy changes, as well as targeted changes to be detailed in 2013, this could be enough to satisfy House Speaker Boehner's insistence that the next increase must be matched with deficit reduction of the same amount (measured over ten years). Since including the debt limit increase in a year-end deal would be advantageous for the White House, the Administration might be willing to make concessions in other areas in order to include it.
Q: What's the working deadline to reach an agreement?
A: December 21. This is the end of the week before Christmas, and members of Congress will be eager to return to their home states in time for the holiday. If a deal has not been finalized by that point but one appears close at hand, Congress might remain in session over the weekend, to December 22 or 23. It is worth noting that in 2010 and 2011, the year-end fiscal agreements (to extend the 2001/2003 tax cuts and the payroll tax cut, respectively) were enacted on December 17 and 23.
Q: What will the path be to that agreement?
A: Bumpy, with periods of inactivity. It is unclear whether the President and congressional leaders will meet before next week, so developments over the coming week may be restricted mainly to comments from different parties to the talks and media reports on the proposals being contemplated. Next week, it seems likely that discussions will intensify somewhat, but serious negotiations seem unlikely until mid-December. Over the next four weeks the headlines out of Washington are likely to be mixed, but we would expect more negative headlines than positive ones, at least until mid-December.