Avoiding a year-end fiscal cliff

WASHINGTON (Reuters) - The November 6 elections are less than six months away, but lawmakers and Washington insiders are already trying to figure out what Congress will do in a post-election session to avoid what is being described as a January 1 "fiscal cliff."

That refers to a series of decisions on budget and tax matters President Barack Obama and Congress will have to negotiate in November and December. If handled poorly, the economic recovery could be threatened, economists fear.

Here is what confronts Washington if nothing is done: At year's end, tax cuts enacted under President George W. Bush expire along with a payroll tax holiday for workers. Doctors treating Medicare patients get a 27 percent pay cut, millions of middle-class taxpayers face paying an alternative minimum tax meant for the rich, and automatic spending cuts start to kick in. Also, the $16.4 trillion debt limit will have to be raised to avoid a U.S. default.

The outcome of the elections will influence the post-election debate, but here are some possible outcomes:

KICKING THE CAN INTO THE 113TH CONGRESS

The post-election session just might end up being the lamest of lame-duck sessions with lawmakers, exhausted from a tough election campaign, deciding to put all of the tough decisions into the hands of a new Congress that will be seated in January.

That is the most likely scenario regardless of which party wins the White House and control of Congress.

Under this scenario, Congress and the White House would agree to extend all the Bush-era tax cuts, most likely for a year, provide temporary alternative minimum tax relief, give Medicare doctors a temporary pay fix and delay automatic spending cuts for both military and domestic programs for six months to a year.

The payroll tax cut for workers might be allowed to expire since it funds the Social Security retirement system, and advocates for the elderly are worried about that program's financing. In that case, the payroll tax for workers would rise to 6.2 percent from 4.2 percent.

Republicans, who are expected to keep control of the House of Representatives, could claim victory with the extension of the Bush tax cuts, while buying time to work on their tax reform plans. Both parties would get more time to work out a long-term spending cut deal. Obama, if he wins re-election, would get the debt ceiling increase he needs to keep government operating, without a drawn-out fight with Republicans over spending cuts.

Even if Republican Mitt Romney wins the presidency, Democrats will likely go along with such a deal. They already will be looking forward to the 2014 congressional elections when they have to defend 20 seats out of the 33 in the 100-member Senate.

Democratic Senate candidates probably would like to kick off their campaigns in 2013 without having to defend an expiration of the Bush tax cuts.

A 'GRAND BARGAIN' DEFICIT REDUCTION DEAL

It seems unlikely that Congress will be able to accomplish in a lame-duck session what has eluded them over the past few years and agree to a "grand bargain" deal of about $4 trillion in spending cuts and tax increases.

But a group of lawmakers in the Senate and the House has not given up hope and is working behind the scenes to draw up legislation in time for the lame-duck session.

Such a bargain would come into play only if financial markets react to Washington's inability to resolve its long-term fiscal problems and start pushing interest rates significantly higher.

A number of analysts say investors are more worried about the coming fiscal cliff throwing the economy back into recession than they are about budget deficits that have been topping $1 trillion a year. That attitude eventually will change, analysts say, if the new Congress fails to come to agreement on a long-term deficit package.

LET THE BUSH TAX CUTS EXPIRE

This is the least likely scenario, but some Democratic strategists are arguing in favor of doing just that because it puts more pressure on Republicans to compromise eventually on a new spending and tax package.

If Congress fails to act by January 1, income tax rates will revert to 2001 levels and the top tax rate would rise to 39.6 percent from 35 percent. Under this scenario, Republicans could then help craft a new tax code with a top income tax rate of say 37 percent and still argue they cut taxes from the 39.6 percent rate.

The problem with this scenario is that allowing the Bush tax cuts to expire would push everyone's taxes higher and would violate Obama's pledge not to raise taxes on the middle class. Some popular items like the $1,000 child tax credit would revert to its previous maximum of $500 per child. Financial markets likely would react badly to the jolt of across-the-board tax hikes.

Alternatively, Obama could try to negotiate a deal with Republicans to keep the tax cuts for the middle class while allowing the top income tax rate to move higher. An incentive for Republicans to accept such a deal, analysts say, would be to continue the low 15 percent tax rate on investment income from dividends and capital gains.

(Reporting By Donna Smith; Editing by Peter Cooney)

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