"Everybody is talking about the fiscal cliff. And I'd be talking about the fiscal cliff, too – if I knew what the hell it was." –David Letterman

The fiscal cliff refers to changes in tax rates and spending that will automatically take place on Jan. 1. The tax hikes are significant. The changes in federal spending are not.

The Congressional Budget Office estimates spending “cuts” associated with the Budget Control Act will total roughly $110 billion this coming year. Half of these “cuts” come from defense and half from non-defense programs. However, these are cuts from projected spending. Projected spending assumes increases due to automatic growth in programs and for inflation. 

Even if specific “cuts” were to occur, federal spending will still grow. Increases in spending for things such as Social Security, Medicare, Medicaid and interest on the debt will continue. Hence, regardless of what happens due to automatic cuts, there will not be a major cut in federal spending. At most, there would be a modest amount of discipline applied to the federal budget.

The tax side is different. Tax increases at the beginning of the year are significant. Most taxpayers would face a tax hike in the vicinity of 10 percentage points. Reducing individuals’ take-home pay by 10 percent would be extremely disruptive to households and to the businesses that depend on the spending. 

There are three possible scenarios for resolving the tax issues associated with the fiscal cliff. The most likely development is a compromise whereby tax rates are increased for upper-income taxpayers ($250,000 for a married couple), as well as for those earning dividends (a 20 percent capital gains tax) and interest income (taxed at marginal tax rates). 

This compromise is consistent with what the President has been suggesting. Taxing income currently used for investment involves eating the seed corn of the economy. It would produce slower growth and perhaps even a recession. Nonetheless, the policy reflects the President’s intent to raise tax rates on those earning higher incomes.

The next most-likely scenario is no decision. In this case, tax increases go into effect for everyone. The President’s advisors have recommended this approach if Republicans insist on keeping their no-tax-increase position. The advisors expect there will be serious economic damage and a public outcry. However, they believe House Republicans would be forced to yield to the President’s plans to avoid even greater damage to the economy.   

A third and least-likely outcome would leave all current tax rates in place through the middle of next year to allow time to work on some form of tax-reform legislation. This is the position favored by Republicans. It’s an outcome that would leave the economy in a better position than either of the first two alternatives.

Given the outcome of the elections, it’s also the least likely of all outcomes.