Plan B For the Fiscal Cliff: Recession Avoidance

In two short weeks, taxes are scheduled to snap back to pre-2001 levels, with a typical median-income household seeing a $2,000 federal income tax hike. Democrats and Republicans agree that such a dramatic tax increase could push the U.S. economy back into recession. With the edge of the cliff in sight, it is time to get realistic and consider Plan B: recession avoidance.

Fiscal cliff negotiations in Washington are about much more than the short-term impact of a change in tax policy. They are also about more fundamental matters, including the appropriate level of federal taxes, the progressivity of the tax system, and the long-run sustainability of our entitlement programs. While Democrats are correct that the federal government cannot be adequately sustained with only the historical levels of tax receipts, Republicans are right to note that no tax policy can be designed to fund the federal government when entitlement spending is projected to consistently grow faster than the overall economy.

These issues are complex and politically charged. The situation calls for shared political sacrifice, with both sides accepting policies they have previously rejected. Republicans must accept additional tax revenues, and Democrats must accept cost-savings reforms to Medicare and other entitlement programs. But little progress has been reported to date, and time is running out.

Both sides have suggested fallback plans. Democrats (and a few Republicans) have urged a temporary extension of tax cuts for everyone earning less than $250,000. Most Republicans have called for a temporary extension of all of the tax cuts, claiming that raising taxes on high-income earners and many businesses is not acceptable unless coupled with broader tax and entitlement reforms. But both approaches have the same flaw: simply delaying tax hikes again will not make the negotiations any easier next year.

Instead, lawmakers should consider a more nuanced Plan B: slowly but deliberately phasing out the key elements of the Bush tax cuts across the board, just as they were phased in. For example, the 39.6 percent top statutory rate was reduced only one percentage point in 2001 and was not scheduled to reach 35 percent until 2006 (although Congress later moved that date forward to 2003). The child tax credit was increased from $500 to $1,000 over ten years, not overnight.

A plan like this could involve:

* Raising the 35, 33, and 28 percent tax brackets back to 39.6, 36, and 31 percent incrementally over five years;

* Reducing the child tax credit $50 per year for ten years;

* Phasing out the 10 percent tax bracket along with marriage penalty relief through 2023;

* Making permanent or extending for four years any remaining provisions, in order to address the uncertainty and complexity induced by the temporary nature of scores of narrow changes enacted in 2001.

Neither side would like this plan, and rightfully so. It contradicts campaign promises made by both parties and fails to either improve the efficiency of the tax system or reform the unsustainable entitlement programs. But such a compromise would avoid a self-induced recession in 2013 and set us on a gradual path to near-term deficit reduction. In other words, it would establish a worst-case scenario for taxpayers that is far less worse than current law. And because it would do so in a way that both sides agree is undesirable, it would create a strong impetus for structural reforms in 2013.

To be clear, a compromise that reined in entitlement spending and brought much-needed simplifications to the tax code would be the best outcome of the fiscal cliff negotiations. But with the new year rapidly approaching, it's time to devise a Plan B.