The Right Way to Resolve the Fiscal Cliff

If Washington politicians were rational, they'd start by extending the deadline by three to six months.

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House Speaker House John Boehner of Ohio, center, leaves a news conference on Capitol Hill in Washington, Thursday, Nov. 29, 2012, after reporting on his private talks with Treasury Secretary Timothy Geithner on the fiscal cliff negotiations.
House Speaker John Boehner abandoned his "Plan B" Thursday night after he could not get the votes from the most conservative members of his caucus.

Democrats and Republicans in Washington have finally stopped preening about the need for bipartisanship, and started to negotiate about the "fiscal cliff" in earnest. This represents the official kickoff of a gaudy political spectacle. There will be regular dueling press conferences with "updates" about nothing. Each side will blame the other on a daily basis for the lack of progress. The over-caffeinated media will air alerts and specials as if the huns are invading.

[ENJOY: Political Cartoons on the Fiscal Cliff]

For anybody keeping score, here's where we stand. President Barack Obama has opened the bidding with many of the same ideas he's been pitching for two years. He wants $1.6 trillion in new tax revenue during the next 10 years, including higher tax rates on households earning more than $250,000 and new limits on deductions. He's willing to approve a one-year delay of the $110 billion in government spending cuts set to start January 1, and he'd cut a modest $400 billion from costly entitlement programs like Medicare. Obama also wants a $50 billion stimulus plan in 2013 and new powers to extend the nation's borrowing limit without having to consult Congress.

Once Republicans stopped laughing, they said Obama's tax hikes were far too much and his cuts to entitlement programs were far too little. Republicans haven't published a formal counterproposal, but in general they favor structural reforms to entitlement programs that would significantly lower costs, along with deep cuts in most other programs, except defense. They might accept fewer tax credits and loopholes for the wealthy, but they want to leave tax rates where they are.

Since there's likely to be a fusillade of leaks, trial balloons, bluffs and perhaps even a few earnest proposals during the next several weeks, here's an outline of what budget experts think would be a rational way to resolve the whole problem:

Extend the deadline. Most of the analysis (and drama) regarding the fiscal cliff focuses on what will happen if some or all of the looming tax hikes and spending cuts go into effect as scheduled at the beginning of 2013. But that's a man-made-and inconvenient—deadline that happens to fall during a lame-duck session of Congress, right after a national election. It would be far more rational to extend the deadline into early or mid 2013, giving the next Congress more time to address some of the most controversial issues in politics.

[RELATED: Republicans Abandoning No-Tax Pledge]

There's one possible trade-off: Another downgrade in the U.S. credit rating. But if investors felt negotiators in Washington were headed toward a bona fide solution to these momentous budget problems, it might not matter much.

Raise taxes modestly. Virtually all reputable budget analysts say there's no way to make a dent in the $16 trillion national debt without meaningful tax increases. Many CEOs agree. Obama's proposals—which target the wealthy but exempt everybody else--may even be insufficient. The 2010 Bowles-Simpson commission, for instance, proposed a range of tax reforms that would simplify the tax code but raise the total tax payments for every income group, including the lowest earners.

Yet the prospect of abrupt tax hikes of an unknown magnitude—which is what we're facing now—is an absurd way to run the economy. The right way to adopt such significant changes is to phase them in gradually and provide at least a year's notice, so consumers and businesses can plan accordingly.

Cut spending significantly. The $110 billion in annual cuts set to begin next year is actually a good start—except that it's happening too soon. The economy is still too weak to absorb a shock of this magnitude, which is why Obama has proposed a one-year delay. (It's a good bet Republicans will ultimately go along with that.)

[SEE ALSO: Another U.S. Credit Downgrade is Coming]

But once the economy is healthier, $110 billion a year in cuts probably won't be enough. During the next decade that would add up to just a little more than $1 trillion. The debt-reduction target most experts think we need to hit is $4 trillion or more. If Obama were to get his $1.6 trillion in new tax revenue, along with $1 trillion in spending cuts, that would still require another $1.4 trillion in spending cuts to reach $4 trillion. The alternative, of course, is to raise taxes by even more.

Fix expensive entitlements. Democrats are talking tough about leaving popular programs like Medicare and Social Security out of the cliff negotiations, but there's really no way to fix the government's finances without overhauling these costly programs. Medicare and Medicaid in particular will eventually swamp the govenrment's finances if they don't become more cost-effective, because of the ever-increasing cost of healthcare. Investors simply won't give credibility to a plan that doesn't address these problems.

Impose a little pain on everybody. As in most negotiations, a good outcome on the fiscal cliff will require everybody to feel like they gave something up. That's why a deal focused solely on taxing the rich more, as one example, would lack credibility if it included no spending cuts or other concessions by the people who tend to be the biggest beneficiaries of government programs. A deal that imposed a little bit of pain on everybody, by contrast, would be believable, and that alone might cheer markets, stoke optimism and boost the economy. As long as it doesn't go into effect tomorrow.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.