What will Part Two of the fiscal cliff fight look like?

January 4, 2013

President Obama says he'll refuse to negotiate over the debt ceiling. But whether he likes it or not, he's going to be negotiating over a major budget agreement in two months' time: The debt ceiling will need to be raised just as the now-delayed sequester starts taking effect, right around March 1.

House Speaker John Boehner at the White House for fiscal cliff negotiations. (Photo by Chip Somodevilla/Getty Images)
House Speaker John Boehner at the White House for fiscal cliff negotiations. (Photo by Chip Somodevilla/Getty Images)

Republicans have made a few things clear about how they'll approach Part Two of the fiscal cliff debate: They will insist on major spending cuts, primarily by targeting entitlement programs, which were left essentially untouched by the Jan. 1 fiscal cliff deal. Earlier rounds of bargaining have already indicated some likely Republican demands (raising the Medicare age) and potential Democratic concessions (chained CPI for Social Security).

But the White House has also made a few things clear. The president will insist that any spending cuts be offset by additional revenue, in a 1:1 ratio. That's why, during this week's fiscal cliff negotiations, the White House pulled out an obscure proposal to change the tax rules for retirement plans in order to delay the sequester. And many Congressional Democrats will be eager to find more tax revenue in future negotiations, as the $650 billion from the fiscal cliff deal falls very short of Obama's original $1.6 trillion revenue target at the opening of the debate. 

That raises the question: If Obama insists on matching any future cuts with more revenue, where will the revenue come from? Offsetting the rest of the sequester alone will require at least $600 billion in revenue if Obama wants to stick to his 1:1 ratio. And the fiscal cliff deal essentially closed the book on the Bush tax cuts, forgoing perhaps the single biggest source of tax revenue by preserving 82 percent of the $3.4 trillion in tax cuts.

But there are a few other areas that Democrats are likely to explore as potential revenue sources.

First, they could open up the individual side of the tax code to changes that go beyond tax rates. Both Obama and House Speaker John Boehner have expressed interest in using some form of cap on deductions and exclusions for wealthy taxpayers, whether through a percentage cap (Obama has proposed one version of this) or a Romney-style dollar limit. In fact, the fiscal cliff deal already makes some headway on this front: It reimposes the PEP and Pease limits on deductions and exemptions (explained here), with a threshold of $250,000 for individuals and $300,000 for families that's significantly below the deal's cut-off for the Bush tax cuts ($400,000/$450,000). And Republicans have at least paid lip service to using this approach to reform the tax code, though it always gets much harder when it comes to working out the details.

Second, Democrats might target other parts of the tax code that give special breaks to the wealthy, such as the carried-interest loophole, for instance, which gives a major tax break to investment managers, or a provision that allows real-estate investors to avoid the capital gains tax. Former White House economics adviser Larry Summers outlines some of the strategies here.

But, politically speaking, it might be tricky to open up the individual tax code again in the search for revenue: Critics would likely charge that the wealthiest have been dealt enough with the tax hikes and that the question of how individuals should be tax is now settled. That said, supporters of the approach could cast at least some of these changes as "tax reform" aimed at making the tax code simpler and more efficient, with fewer loopholes.

The other potential area for revenue would be the corporate side of the tax code. Liberal Democrats have already criticized corporations for gaming the tax code in order to pay as little as possible, even as their profits have soared to new highs. In 2011, corporations paid the lowest average taxes as a share of profits since 1972 — 12.5 percent. Critics believe this is unfair and want corporations to have to contribute more to federal revenues. Plus, there's already an appetite on left and right to get rid of corporate tax giveaways. 

The problem is that Republicans have long pushed for revenue-neutral corporate tax reform, and the White House has suggested that it would go along with it. Loopholes and other tax giveaways would be eliminated, but only on the condition that rates would be lowered, leaving the overall corporate tax burden much the same. So the White House would either have to shift gears and push for revenue-positive corporate tax reform — establishing the framework for a huge future overhaul, with some kind of downpayment — or try to nibble at the edges of the corporate tax code and find some relatively minor giveaways to cut. Either proposal would be a hard sell for Republicans who want a revenue-neutral overhaul, and corporate tax lobbyists would be up in arms. 

In all of these cases, Democrats will have to figure out how to sell the reforms, politically speaking, both on the Hill and beyond. Their message on letting the Bush tax cuts expire for upper-income earners was clear: Don't hold the middle class hostage for the sake of the wealthiest. The road ahead is now murkier, in terms of the politics and the policy. 

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