Fiscal Cliff, Fiscal Abyss or Fiscal Three-Card Monte?

By Robert A. Green, CPA

Democrats view tax reform as starting from Clinton-era tax rates in 2013 on the upper-income and lowering tax rates back to Bush-era rates from 2012, in exchange for limiting deductions. In their view, that does not violate the tax-protection pledge signed by many Republicans and some Democrats, because tax rates are reduced in exchange for limiting tax deductions. Democrats figure the Bush-era tax cuts were passed in a reconciliation procedure with a required 10-year sunset provision, so therefore when the temporary tax cuts expire, it's not deemed a tax hike but a rather a return to sunrise tax policy. This is the key obstacle to making a deal to reduce the shock of the fiscal cliff in the lame duck session.

Even controversial Grover Norquist agreed that reducing tax deductions in exchange for lower tax rates is not a violation.

Barron's cover story

by Gene Epstein points out that the fiscal cliff is heavily stacked toward tax hikes in 2013 (he calculates $475 billion) vs. 2013 spending cuts of $111 billion; the often cited $1 trillion in cuts spans 10 years.

If passed, the 2012 AMT patch will trim $114 billion off the fiscal cliff. Perhaps Congress should only pass the AMT patch for the middle class. Extending the Bush-era tax cuts for everyone other than the upper income and will trim another $95 billion off the fiscal cliff. That's around $200 billion of less fiscal cliff shock on the middle class, which surely reduces shock waves on the economy.

Extending Bush-era tax rates on the upper income but limiting their tax deductions will generate close to $50 billion of tax hikes on a static basis, and from growth, too. That new tax revenue helps the deficit. Ending the temporary payroll tax cut stimulus at year-end as scheduled will add back $120 billion in tax revenues. That's close to $170 billion of new 2013 tax revenues vs. $110 billion of 2013 spending cuts. This is good balance that should satisfy President Obama's requirement. If Congress and the President don't like the automatic 2013 sequester with 50/50 non-defense vs. defense spending cuts, then find different spending cuts to replace them.

President Obama won reelection, Democrats added to their majority in the Senate and Republicans retained safe control of the House. We're left with the same leaders and negotiators to the fiscal cliff and upcoming debt-ceiling crisis. But President Obama feels he has an edge after the election and that honeymoon lasts through the lame duck session.

This past week after the election, the leaders started fiscal-cliff negotiations through the media — the new style set by President Obama. The President is pushing hard to let the Bush-era tax rates expire on the upper-income only, as promised. Obama has to start his post-election fiscal-cliff negotiations from that position, and he won't surrender it easily, although he may to strike a deal in the lame duck.

In the president's public talk from the White House on Friday, he also seemed to leave the door open to tax hikes on the upper income through

like reduced tax expenditures for the upper-income. The President said he is open to ideas from Republicans, who hinted at the same type of other means to raise new tax revenue on a static basis, not just through growth which is the preferred Republican approach.

Speaker Boehner seemed to strike a conciliatory tone this week, hinting he would agree to tax hikes on the rich on a static basis, and not just from growth through tax reform – with lowering tax rates. Speaker Boehner said he would obstruct tax rate hikes, meaning he won't allow the Bush-era tax rates to expire on the rich only.

Both President Obama and Gov. Mitt Romney included a haircut on tax deductions for the rich in their tax plans, so there is common ground between the parties on this approach to tax reform. It was also advocated in Bowles Simpson and the Gang of Six in their deficit, spending and tax reform plans.

I think there is common ground here for striking a deal in the lame-duck session. Perhaps Speaker Boehner might accept President Obama's idea of limiting itemized deductions to a tax rate of 28% (rather than 35%), thereby raising taxes on the upper income. It will probably take a bigger haircut for the math to add up.

If Congress reduces itemized deductions for 2013, it may be better for the upper income to accelerate their tax deductions into 2012 – provided there's no AMT triggered on them — rather than defer itemized deductions into 2013. I suggest this in my last blog

Speaker Boehner agreeing to the above itemized-deduction haircut on the rich would likely constitute his suggested "down payment" on tax reform, which should be hopefully be completed in 2013.

In the last crisis round of negotiations over the debt ceiling and tax policy in mid-2011, President Obama insisted on delaying the debt ceiling and fiscal cliff crisis until after his reelection, which left little time to craft a deal in a lame-duck session. Now that President Obama has won his reelection, will the President keep his promise to end Bush-era tax rates for the upper income at year-end 2012? Or will the President blink in fear of a CBO-forecasted fiscal-cliff-induced recession, accept some tax revenue hikes through other means and extend the Bush-era tax rates for

into 2013? I think the President will make this type of deal if he can. But, I hope the President doesn't spike the ball about breaking the tax protection pledge since that's not clear and Democrats don't want that label, either.

With whatever deal is forged in the lame duck session, I doubt Republicans will surrender their leverage of not de-coupling Bush-era tax rates — for the middle-class vs. upper-income — or giving the President a blank check on a debt-ceiling vote. Their starting point for negotiations is new tax revenue through tax reform and growth only. Republicans want to lower rates starting with the Bush-era rates, not the Clinton-era rates on the rich. They also want specific spending cuts and entitlement reform before they agree to new revenues and tax reform.

It's impossible to negotiate and draft detailed legislation for entitlement reform and tax reform in the lame duck; that should be the job of the next Congress. It's crazy to make last-minute significant changes to the tax code and then reform it in a material fashion just a few months later. The IRS will be spun into a real mess and taxpayers will face great cost and headaches in compliance.

I hope President Obama learned his lessons from the last breakdown in deficit, spending and tax talks and he read Bob Woodward's book

. We don't have time in the lame duck session for the President and other leaders to back track and not honor their negotiated points.

Senate Minority Leader Mitch McConnell drew a hard line in the sand after the election against any new tax hikes in the fiscal cliff showdown. He did not play cute like the others distinguishing between tax-rate hikes vs. new tax revenue through other means. Will Senator McConnell accept a Boehner down-payment on tax reform which includes new static tax revenue on job creators, providing Bush-era tax rates are continued on

into 2013? Will Senate Leader Reid try to ice McConnell by threatening his right to use the filibuster? McConnell could face a primary challenge from the Tea Party in 2014 so that may color his stated posture.

Both party's leaders are playing that game. Democratic leaders are threatening to go over the fiscal cliff and let all the Bush-era tax rates expire, not pass a 2012 AMT patch and seek to pass tax cuts retroactively to Jan. 1, 2013 (and hopefully the AMT patch retroactive to 2012). Republicans won't de-couple Bush-era tax cuts or give the President a blank check on the debt ceiling. The American people should not stand for this political grandstanding, and although we don't need a grand bargain now, we want a reasonable small ball deal in the lame duck to limit the damage of the fiscal cliff.

In

I guessed President Obama might not agree to extend the Bush-era tax rates for the upper income and Republicans wouldn't decouple the middle-class Bush-era tax rates. With that potential outcome, I suggested taxpayers might want to accelerate income and expenses since tax rates would skyrocket higher in 2013, and tax deductions may be limited in 2013 with tax reform. Don't take for granted that Washington can rebuild Humpty Dumpty after the new year, either.

I hope Congress and the President strike a post-election lame-duck deal to extend the Bush-era tax rates on

and, as Speaker Boehner suggests, do a down-payment on tax reform by limiting deductions in 2013 for the rich. If that works out to be the case, then upper-income taxpayers may want to defer income and accelerate expenses, which is typical year-end tax planning. Read our normal

on our Website.

Senator John Kyl told CNBC's Larry Kudlow they can easily find $55 billion of spending cuts over six months for a lame-duck punting deal and that is all they need to kick the can down the road. As Larry Summers said, 10-year spending promises are worthless, since Congress never honors them and changes things each new Congress or year, anyway. We're not really taking about spending cuts, but rather reductions in spending growth.

Everyone has a different take on the fiscal cliff story. Some want to go over the fiscal cliff to avoid the inevitable long-term fiscal abyss. Isn't the fiscal cliff the medicine that Congress and the President prescribed? Are the patient and doctor trying to skip bad-tasting medicine?

Financial markets are high vs. the meltdown prices in 2008, and Helicopter Ben Bernanke of the Fed is keeping unending quantitative easing to buttress asset and market prices. Can't the markets absorb a modified fiscal cliff based on the above suggested deal?

Our CPAs are standing by to help our clients with year-end tax planning and we hope to see a fixed target rather than moving goal posts. This will get interesting!