Senate approves 'fiscal cliff' deal, crisis eased

1 of 9. U.S. Senate Majority Leader Harry Reid (D-NV) (center) departs with an aide, after a senate vote in the early morning hours, from the U.S. Capitol in Washington January 1, 2013.

Credit: Reuters/Jonathan Ernst

By David Lawder and Richard Cowan

WASHINGTON | Tue Jan 1, 2013 2:59am EST

WASHINGTON (Reuters) - The Senate moved the U.S. economy back from the edge of a "fiscal cliff" on Tuesday, voting to avoid imminent tax hikes and spending cuts in a bipartisan deal that could still face stiff challenges in the House of Representatives.

In a rare New Year's session at around 2 a.m. EST (0700 GMT), senators voted 89-8 to raise some taxes on the wealthy while making permanent low tax rates on the middle class that have been in place for a decade.

But the measure did little to rein in huge annual budget deficits that have helped push the U.S. debt to $16.4 trillion.

The agreement came too late for Congress to meet its own deadline of New Year's Eve for passing laws to halt $600 billion in tax hikes and spending cuts which strictly speaking came into force on Tuesday.

But with the New Year's Day holiday, there was no real world impact and Congress still had time to draw up legislation, approve it and backdate it to avoid the harsh fiscal measures.

That will need the backing of the House where many of the Republicans who control the chamber complain that President Barack Obama has shown little interest in cutting government spending and is too concerned with raising taxes.

All eyes are now on the House which is to hold a session on Tuesday starting at noon (1700 GMT).

Obama called for the House to act quickly and follow the Senate's lead.

"While neither Democrats nor Republicans got everything they wanted, this agreement is the right thing to do for our country and the House should pass it without delay," he said in a statement.

"There's more work to do to reduce our deficits, and I'm willing to do it. But tonight's agreement ensures that, going forward, we will continue to reduce the deficit through a combination of new spending cuts and new revenues from the wealthiest Americans," Obama said.

Members were thankful that financial markets were closed, giving them a second chance to return to try to head off the fiscal cliff.

But if lawmakers cannot pass legislation in the coming days, markets are likely to turn sour. The U.S. economy, still recovering from the 2008/2009 downturn, could stall again if Congress fails to fix the budget mess.

"If we do nothing, the threat of a recession is very real. Passing this agreement does not mean negotiations halt, far from it. We can all agree there is more work to be done," Majority Leader Harry Reid, a Democrat, told the Senate floor.

A new, informal deadline for Congress to legislate is now Wednesday when the current body expires and it is replaced by a new Congress chosen at last November's election.

The Senate bill, worked out after long negotiations on New Year's Eve between Vice President Joe Biden and Senate Republican Minority Leader Mitch McConnell, also postpones for two months a $109 billion "sequester" of sweeping spending cuts on military and domestic programs.

It extends unemployment insurance to 2 million people for a year and makes permanent the alternative minimum tax "patch" that was set to expire, protecting middle-income Americans from being taxed as if they were rich.

'IMPERFECT SOLUTION'

The tax hikes do not sit easy with Republicans but conservative senators held their noses and voted to raise rates for the rich because not to do so would have meant increases for almost all working Americans.

"It took an imperfect solution to prevent our constituents from a very real financial pain, but in my view, it was worth the effort," McConnell said.

House Speaker John Boehner - the top Republican in Congress - said the House would consider the Senate deal. But he left open the possibility of the House amending the Senate bill, which would spark another round of legislating.

"The House will honor its commitment to consider the Senate agreement if it is passed. Decisions about whether the House will seek to accept or promptly amend the measure will not be made until House members ... have been able to review the legislation," Boehner and other House Republican leaders said in a statement.

Boehner has struggled for two years to get control over a group of several dozen Tea Party fiscal conservatives in his caucus who strongly oppose tax increases and demand that he force Obama to make savings in the Medicare and Social Security healthcare and retirement programs.

A campaign-style event held by Obama in the White House as negotiations with Senate leaders were taking place on Monday may have made it more difficult for Republicans to back the deal. In remarks to a group of supporters that resembled a victory lap, the president noted that his rivals were coming around to his way of seeing things.

"Keep in mind that just last month Republicans in Congress said they would never agree to raise tax rates on the wealthiest Americans. Obviously, the agreement that's currently being discussed would raise those rates and raise them permanently," he said to applause before the Senate deal was sealed.

Obama's words and tone annoyed Republican lawmakers who seemed to feel that the Democrat was gloating.

"That's not the way presidents should lead," said Republican Senator John McCain, Obama's rival in the 2008 election.

A deal with the House on Tuesday, while uncertain, would not mark the end of congressional budget fights. The "sequester" spending cuts will come up again in February as will the contentious "debt ceiling," which caps how much debt the federal government can hold.

Republicans may see those two issues as their best chance to try to rein in government spending and clip Obama's wings at the start of his second term.

(Additional reporting by Richard Cowan, Mark Felsenthal, Rachelle Younglai, Kim Dixon and Jeff Mason; Writing by Alistair Bell; Editing by Eric Walsh)

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Analysis: At cliff's edge, old ideas to cap tax breaks are new again

By Kim Dixon and Kevin Drawbaugh

Mon Dec 31, 2012 3:57pm EST

n">(Reuters) - Imposing overall caps on how much high-income people in the United States can claim on their tax returns in deductions, exemptions and other tax breaks is an idea whose time may have come - again.

In the whirl of "fiscal cliff" talks, bipartisan backing has grown for imposing, or in some cases reinstating, caps on tax breaks for top earners.

On Monday, Republicans threw their support behind several approaches to do just that in a framework to step away from the fiscal cliff of $600 billion in new taxes and spending cuts set to take effect on January 1.

Under an emerging deal brokered by Republican Senate Minority Leader Mitch McConnell and Democratic Vice President Joe Biden, curbs on deductions and exemptions for households earning more than $300,000 would be re-imposed, according to a source close to the talks.

For several years, Democratic President Barack Obama has proposed re-imposing the limits. Republicans have opposed such caps for more than a decade, but the idea may be coming full circle.

These limits "were originally done in 1990 at the behest of the Republicans who didn't want tax rates to go up," said Michael Graetz, a Columbia University tax law professor and a former top Treasury Department official.

The main reason for the switch now? The urgent search for politically achievable paths to avoid falling off the fiscal cliff of sharp tax increases and spending cuts.

Talks on avoiding the cliff were moving along on Monday with the fresh offer from McConnell and Biden.

The beauty of the approaches, backers say, is that they let politicians raise government revenue without raising tax rates as much, said economists, Republicans and congressional aides.

Moreover, a strategy that caps several tax breaks broadly could be more expedient than trying to curb tax breaks one at a time that would incur the wrath of lobbyists who would fight them all the way.

Lawmakers are sizing up several ideas.

PEP AND PEASE

Two ideas backed by McConnell are reinstating the personal exemption phase-out (PEP) and so-called Pease limits on itemized deductions. Both were created in 1990 in a budget deal between Republican President George H.W. Bush and Democrats in Congress.

PEP and Pease - often viewed as a package deal - both reduce how much high-income taxpayers can claim in personal exemptions, in the case of PEP, and itemized deductions, in the case of Pease. Both measures work to raise taxes on top earners, without explicitly raising the tax rates that they pay.

When first imposed more than two decades ago, "they were ways to keep the rate at a certain level," Graetz said.

So how do they work?

PEP deals with the personal exemptions that taxpayers claim near the top of the Internal Revenue Service's Form 1040. Taxpayers claim exemptions for themselves, their spouses and their dependents. Last year, each exemption was worth $3,800.

The Pease limit - named after its author, former Ohio Democratic Representative Don Pease - applies to itemized deductions, such as the ones taken for mortgage interest, charitable giving and state and local taxes paid.

By reducing the values of exemptions and deductions, both PEP and Pease would work to raise the taxable income of wealthier people and, as a result, the taxes they pay.

Under a previous proposal offered by Obama, reinstating them would raise about $165 billion in new tax revenue over 10 years, the Tax Policy Center estimated.

Both limits were gradually eliminated under President George W. Bush. By 2010 they were history, a status which was extended for two years by Obama in an agreement with Republicans.

28 PERCENT CAP

Another idea is Obama's proposal to cap the value of tax deductions and certain tax exemptions for high-income taxpayers.

The president's proposal would limit the value of these tax breaks as one moves to a higher tax bracket. For example, a taxpayer in the current 35 percent tax bracket with $100,000 worth of qualified deductions and exemptions gets a $35,000 tax break. Under the 28 percent limit, that taxpayer would only get a $28,000 tax break.

Such a change would raise about $580 billion over a decade, according to a White House estimate, a significant chunk of revenue.

"Republicans have resisted it since the president proposed it," said Alan Viard, an economist at the conservative-leaning American Enterprise Institute think tank.

But a top Republican aide has said that House of Representatives Speaker John Boehner was willing to consider the president's proposed cap in budget talks with Obama.

Viard said that the idea fits with Republican support for broadening the tax base in exchange for lower tax rates.

There are limits already in place for some tax breaks, such as the $1 million limit for home mortgages.

(Editing by Howard Goller and Mohammad Zargham)

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Analysis: Economy would dodge bullet for now under fiscal deal

U.S. Senate Minority Leader Mitch McConnell (C) departs the senate floor with an aide after a senate vote in the early morning hours at the U.S. Capitol in Washington January 1, 2013.

Credit: Reuters/Jonathan Ernst

By Jason Lange

WASHINGTON | Tue Jan 1, 2013 2:52am EST

WASHINGTON (Reuters) - A deal worked out by U.S. Senate leaders to avoid the "fiscal cliff," was far from any "grand bargain" of deficit reduction measures.

But if approved by the U.S. House of Representatives, it could help the country steer clear of recession, although enough austerity would remain in place to likely keep the economy growing at a lackluster pace.

The Senate approved a last-minute deal early Tuesday morning to scale back $600 billion in scheduled tax hikes and government spending cuts that economists widely agree would tip the economy into recession.

The deal would hike taxes permanently for household incomes over $450,000 a year, but keep existing lower rates in force for everyone else.

It would make permanent the alternative minimum tax "patch" that was set to expire, protecting middle-income Americans from being taxed as if they were rich.

Scheduled cuts in defense and non-defense spending were simply postponed for two months.

Economists said that if the emerging package were to become law, it would represent at least a temporary reprieve for the economy. "This keeps us out of recession for now," said Menzie Chinn, an economist at the University of Wisconsin-Madison.

The contours of the deal suggest that roughly one-third of the scheduled fiscal tightening could still take place, said Brett Ryan, an economist at Deutsche Bank in New York.

That is in line with what many financial firms on Wall Street and around the world have been expecting, suggesting forecasts for economic growth of around 1.9 percent for 2013 would likely hold.

At midnight Monday, low tax rates enacted under then-President George W. Bush in 2001 and 2003 expired. If the House agrees with the Senate - and there remained considerable doubt on that score - the new rates would be extended retroactively.

Otherwise, together with other planned tax hikes, the average household would pay an estimated $3,500 more in taxes, according to the Tax Policy Center, a Washington think tank. Budget experts expect the economy would take a hit as families cut back on spending.

Provisions in the Senate bill would avoid scheduled cuts to jobless benefits and to payments to doctors under a federal health insurance program.

AUSTERITY'S BITE

Like the consensus of economists from Wall Street and beyond, Deutsche Bank has been forecasting enough fiscal drag to hold back growth to roughly 1.9 percent in 2013. Ryan said the details of the deal appeared to support that forecast.

That would be much better than the 0.5 percent contraction predicted by the Congressional Budget Office if the entirety of the fiscal cliff took hold, but it would fall short of what is needed to quickly heal the labor market, which is still smarting from the 2007-09 recession.

"We continue to anticipate a significant economic slowdown at the start of the year in response to fiscal drag and a contentious fiscal debate," economists at Nomura said in a research note.

In particular, analysts say financial markets are likely to remain on tenterhooks until Congress raises the nation's $16.4 trillion debt ceiling, which the U.S. Treasury confirmed had been reached on Monday.

While the Bush tax cuts would be made permanent for many Americans under the budget deal, a two-year-long payroll tax holiday enacted to give the economy an extra boost would expire. The Tax Policy Center estimates this could push the average household tax bill up by about $700 next year.

The suspension of spending cuts sets up a smaller fiscal cliff later in the year which still could be enough to send the economy into recession, said Chinn.

He warned that ongoing worries about the possibility of recession could keep businesses from investing, which would hinder economic growth.

"You retain the uncertainty," Chinn said.

(Reporting by Jason Lange; Editing by Eric Walsh)

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