What the 'Fiscal Cliff' Means

As deadline approaches, Duke faculty discuss the budget negotiations and what can go wrong

President Obama and congressional leaders are both warning that the approaching "fiscal cliff" could send the U.S. economy back into recession, but some Duke experts say the uncertainty surrounding the negotiations has already hurt the economy.

Nearly $500 billion in automatic tax hikes and spending cuts are set to kick in Jan. 1 if the White House and Congress don't reach a deal required by the Budget Control Act of 2011. The legislation requires President Obama and Congress to create a nine-year, $1.2 trillion deficit-reduction plan by Jan. 1, 2013.

Failure would mean $109 billion in cuts to annual defense and non-entitlement programs. The Bush-era 2 percent payroll-tax reduction, extended unemployment benefits and other programs would also expire.

The prolonged lack of a deal to avert the terms of the act from taking effect is already hurting individuals and business, said John Buley, a consulting professor of finance at The Fuqua School of Business.

"Every family and every business in America needs certainty on personal and corporate taxes rates," he said. "You may or may not like the Bush-era tax cuts, but before corporations will spend, they need to know how their investments will be taxed. Individuals also need to know how their personal investments will be taxed."

Buley added that the dramatic cuts that could result from no deal "will be profound," including the possibility of a 3 percent or more decline in GDP that would sink the United States back into recession.

Politically, some Duke faculty members said Obama and the Democrats hold the upper hand in negotiations.

"Certainly it seems that President Obama is determined to get the maximum bargain he can and believes he holds the whip hand for a number of reasons," said Peter Feaver, a professor of political science and public policy. "One of those reasons may be that he does not fear the defense cuts of sequestration as much as some Republicans and some on his defense team do."

As for negotiating a deal to avert the terms of the Budget Control Act of 2011, political scientists John Aldrich and David Rohde agreed that Republicans have the most to lose.

"It looks as though the Republicans have more to lose -- big tax increases, losing Bush-era tax cuts and big cuts in defense, though not as big as the cuts to entitlement programs -- if we do go over the cliff fully," Aldrich said. "All of this gives a little bit of bargaining leverage to Obama and the Democrats."

Rohde said even if nothing is accomplished before the Jan. 1 deadline, Congress could take action retroactively to deal with the impact.

"If we pass that date I expect that the stock market might be very rattled, but the new Congress, bolstered by the Democrats, could change the tax rates, for example, for those earning below $250,000, and there would be no consequence for those people," Rohde said. "A similar thing would be nearly true for the spending levels. This, too, strengthens the Democrats hand."

Lawrence A. Zelenak, a law professor who specializes in tax law, said a major victim of a retroactive deal would be the Internal Revenue Service.

The agency "will be faced with the thankless task of deciding how to administer the tax laws when the law-on-the-books says one thing, but everyone knows the law is likely to be amended retroactively to say something quite different," he said.

Negotiations to avert the fiscal cliff between Congress and the Obama administration could open the door to further discussions about health reform, said Donald Taylor Jr., an associate professor of public policy at the Sanford School.

"A key goal of the Obama administration is to set the implementation of the Affordable Care Act, especially in Republican-controlled states," Taylor said. "If a large-scale, long-range deal is struck to raise taxes, it will very possibly include modifications to the health reform law, Medicare and Medicaid."

But with no action taken yet to avert the fiscal cliff, the United States' reputation for consistency and leadership in the world continues to take a hit, Buley said.

"'Mutually assured destruction' was considered the only way to get a deal done. Here we are in November and little progress has been made," he said. "The world is waiting for leadership."