Brace Yourself

The United States should get ready to go off the fiscal cliff.

Without congressional action, broad tax increases and spending cuts will automatically take effect on January 2. The Bush-era tax cuts, the Alternative Minimum Tax patch, and the temporary payroll tax reduction will expire. The extension of unemployment benefits will lapse, and payments to physicians under Medicare will be reduced. And, of course, the sequestration mechanism contained in last year's Budget Control Act will cut planned defense and domestic discretionary spending by about $1 trillion over the next 10 years.

The combined effect of deep spending cuts and substantial tax increases would remove more than $600 billion from the economy in 2013 and send the United States back into recession. The Tax Policy Centerestimates that taxes on the average middle-income household would increase by nearly $2,000. And the Congressional Budget Officeprojects that, if we go off the fiscal cliff, U.S. gross domestic product would shrink by 0.5 percent (instead of growing by 1.7 percent) and unemployment would reach 9.1 percent (instead of 8 percent).

The national security establishment has focused primarily on the potential cuts to the Pentagon, which would total some $500 billion over the next decade. In their third debate, Mitt Romney warned Barack Obama that such cuts would devastate the military, leading the president to promise: "It will not happen." But the likelihood of cuts to defense spending cannot be considered in isolation from all the other elements of the fiscal cliff, and with the election behind us, it's time to admit there is a strong possibility that sequestration will take effect -- because both the president and Congress could benefit politically.

Just consider the likelihood of these three scenarios:

Scenario 1: Congress and the president agree to a grand bargain.

Although structural factors seem to favor a deal, the 112^th Congress's political gridlock -- it has passed the fewest laws of any session since World War II -- as well as the extremely short time available to forge a large, complicated piece of legislation almost certainly means that Congress and the president will not strike a grand bargain before January 2.

At first glance, the prospects for such a deal seem higher than at any point during the past two years. President Obama's bargaining power has increased now that he has received a clear mandate for the next four years. Additionally, allowing tax breaks to expire means that taxes will increase, which many Republicans oppose. For their part, Democrats want to prevent large cuts to domestic discretionary spending, and they have an incentive to cut a big deal before the nation hits the debt ceiling again, likely early in 2013. Leaders from both parties oppose the sequestration defense cuts. And, of course, neither side wants the country to plunge back into recession.

The fundamental problem is that most Republicans do not support any tax increases and most Democrats do not support significant cuts to government services. What's more, even if Congress were inclined to compromise, the logistics of passing a grand bargain are daunting. There are only seven weeks until this congressional session ends. Some time will be taken up preparing for the 113^thCongress, and many departing members will focus on making arrangements for their post-Congress lives rather than legislating. In that context, Congress would have to draft legislation; debate and pass it in committees; debate and pass it in both houses; come up with a compromise agreement between the two chambers; redraft the compromise; and then pass the conference report. Then the president would have to sign that bill into law.

Barring an unforeseen change, the cumulative effect of partisan gridlock and a lack of time should squelch expectations for a grand bargain in the lame duck.

Scenario 2: Congress and the president agree to delay all or parts of the fiscal cliff, possibly including the sequester.

If Congress and the president fail to strike a comprehensive deal, they will face substantial pressure to delay some or all of the fiscal cliff provisions, including sequestration, before they take effect on January 2. A delay would have many of the same short-term positive effects for the economy as a grand bargain. It would also defer deep cuts to defense and domestic programs.

The bargaining over a possible delay could resemble a scaled-down version of trying to reach a grand bargain. The lack of comity between the two parties on the Hill suggests that even a scaled-down agreement would face a difficult and contentious, if not impossible, path. Any deal to delay some or all of the fiscal cliff issues would occur only at the last minute, after lesser agreements had failed, and in a "clean" bill stripped of any other legislative measures.

However, the effects of a delay would differ from those of a grand bargain in one significant regard: the potential market reaction. Financial markets may react poorly if the deficit reduction measures enacted in the Budget Control Act of 2011 are delayed without having reached a bigger deal, because it would signal that Washington lacks the political will to solve its fiscal problems. Both Fitch Ratings and Moody's Investor Services have warned of a credit downgrade if Congress and the president do not reach an agreement that prevents the country from going off the fiscal cliff, increases the U.S. debt ceiling, and creates a plan for reducing the budget deficit and stabilizing the federal debt. As former Senators Sam Nunn and Pete Domenici wrote in October, "Absent more constructive action, simply postponing when we go over the cliff could hurt business confidence, worry investors and lead to another disruptive debate over raising the debt ceiling."

Republicans have strong incentives to press for a delay, since that would avoid substantial tax increases and cuts to defense spending in the short term. In early 2013, Republicans will also gain new leverage as the nation once again reaches its debt ceiling, which will require Congress to authorize additional government borrowing. This is an immensely powerful bargaining chip, as was amply demonstrated in the summer of 2011 when Republican deficit hawks withheld their support for raising the debt ceiling until they received concessions on deficit reduction. They may use those hardball tactics again in 2013, possibly in the midst of negotiations to reach a larger bargain on spending and revenues. Delaying sequestration for several months could thus hand congressional deficit hawks yet another source of negotiating leverage.

Conversely, the president and many congressional Democrats would lose a lot of bargaining power by agreeing to a delay. Unless Democrats concluded that the public would blame them -- and them alone -- for going off the fiscal cliff, there is little incentive for them to postpone the day of reckoning.

Scenario 3: Congress and the president fail to reach any agreement, and the nation goes off the fiscal cliff.

Continued gridlock during the lame duck session remains a high probability, and budget talks will likely involve a significant amount of brinksmanship among negotiators trying to maximize their own gains -- brinksmanship that could well end in failure, preventing a deal and driving the nation off the fiscal cliff.

As noted above, the tight legislative calendar in the lame duck session and the large number of weighty issues on the docket makes it very likely negotiations on any sizable deal will continue until the last possible moment. If talks break down at that point, the time left to agree to a delay would be very short. Efforts to broker a delay agreement would probably have to be moving at the same time as efforts to agree on a grand bargain. But lawmakers looking for a deal would likely shun simultaneous efforts, lest the possibility of delay remove the time pressure needed to reach a bargain.

Although President Obama has strongly opposed sequestration as a way to reduce the deficit, it remains unclear whether he would support legislation to undo it without an agreement on new sources of revenue. In August, he told a Virginia newspaper, "If the choice is between sequester going through or tax cuts continuing for millionaires and billionaires, I think it's pretty clear what the American people would choose." But the president also clearly stated during the final presidential debate that sequestration "will not happen." Although his spokesmen walked back that language the following day, it remains unclear to what degree Obama sees sequestration as an unacceptable outcome. Republicans leaders, on the other hand, have demonstrated their equally strong opposition to new taxes.

Some legislators from both parties might see advantage in letting the nation go off the fiscal cliff and allowing the sequester cuts to take effect. According to press reports, some Republicans have promised to slow down the legislative process to ensure that there is no deal to delay the cuts. For Republicans deficit hawks, ensuring that Congress reduces government spending, whatever the consequences, is the highest priority. Grover Norquist, the influential head of Americans for Tax Reform, recently stated, "Sequestration is not the worst thing"; and Rep. Jim Jordan (R-Ohio), who chairs the conservative Republican Study Committee, has said, "The only thing worse than cutting national defense is not having any scheduled cuts at all take place." For Democrats, going off the fiscal cliff would improve their bargaining position with Republicans -- taxes would rise significantly and defense spending would be cut.

In a perverse twist of logic, both parties might benefit from the new baselines created by going off the fiscal cliff. Allowing the Bush-era tax cuts to expire would automatically raise taxes on the majority of Americans to pre-2001 levels, which would reduce the deficit by $3.7 trillion over the next decade. With sequestration in force, spending would be cut by about $1 trillion over 10 years, carved equally out of defense and non-defense discretionary accounts. Ironically, these new baselines might actually break the partisan deadlock because Republican lawmakers could then vote in favor of a tax "cut," and as revenues increase, more Democratic lawmakers may be willing to vote to "increase" spending on defense programs.

Of course, this would be high-stakes game of chicken for both the White House and Congress. It would seriously disrupt planning throughout the Department of Defense and defense industry, shake market confidence in the United States, and slow U.S. economic growth. But recent reports have indicated that the effects of defense sequestration, tax hikes and spending cuts would be slowerand less damaging in the short term than the rhetoric would suggest -- leaving room to go off the cliff and cut a deal early in the 113^th Congress without causing lasting damage to the economy, national security, or domestic programs. Lawmakers from both parties might therefore see going off the cliff as a practical way of reaching a broader consensus in 2013 about balancing the nation's revenues and expenditures.

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If we do go off the fiscal cliff, all is not lost for the Pentagon. The exact effects of allowing sequestration to take effect still remain unclear, but they are likely to occur more gradually than generally understood. Sequestration mandates a $52.3 billion reduction of DOD spending in Fiscal Year (FY) 2013, which amounts to a 9.4 percent cut of budget authority from nonexempt accounts during the nine remaining months of FY 2013.

Focusing on the $52.3 billion cut to defense budget authority distorts how sequestration would affect defense spending for the rest of the fiscal year. Budget authority is often spread across multiple years and therefore is an improper metric for examining the immediate impacts of cuts in economic terms. Instead, outlays -- money actually spent -- provide a better measure.

Some of the key ways that sequestration could affect defense during the rest of FY 2013 include:

• The DOD civilian workforce. As spending on civilian personnel is largely consumed in the first outlay year, the civilian workforce potentially faces significant layoffs or furloughs. Unlike uniformed personnel, civilian personnel are not exempt from sequestration. Expert analysts have estimated that if sequestration goes into effect, DOD would need to reduce its civilian workforce by as much as 13.7 percent during the remainder of the fiscal year.

• Military health care. Military health care services are subject to sequestration since they are primarily funded through nonexempt operations and maintenance accounts. This could result in delayed payments to providers and possible denial of services.

• Program cancellations. Despite widespread concern, most procurement programs will not be affected right away. Sequestration does not affect prior-year funding obligations, so already authorized and planned purchases will go ahead as scheduled. Sequestration allows already planned programs to continue, but over time it would reduce quantities bought, delay deliveries, and increase unit prices.

• Military end strength. Since President Obama exercised his authority to shield military personnel accounts from sequestration, pay and benefits would remain intact and end strength would not be cut beyond already-planned levels for FY 2013.

The Pentagon would likely try to mitigate some of these effects by asking Congress for liberal reprogramming authority, in order to shift money from one account to another. If Congress grants this authority, DOD would be able to allocate any defense cuts strategically rather than being forced to cut each plan, program and activity would equally during FY 2013. It would likely shift funds away from lower-priority base budget operations and maintenance accounts to fund higher priorities, such as the Overseas Contingency Operations budget that supports deployed troops.

The Defense Department might also mitigate these effects by deferring any cuts until the fourth quarter of FY 2013. Under such a plan, the department would continue operating at planned FY 2013 spending levels as specified in the continuing resolution until a decision is made by Congress and signed by the president to undo the cuts. This would allow the Pentagon to continue resourcing ongoing operations and maintain readiness at existing levels for the near term. Of course, this would be a very high-stakes gamble: if Congress did not reverse sequestration or increase the DOD budget for the fourth quarter, the effects would be devastating. Going off the fiscal cliff might not be as bad as many analysts have warned -- and it might even have some political benefits -- but that doesn't mean the risks aren't significant.