A third option changes the negotiation

The conventional wisdom on the fiscal cliff is that there are two options: (1) an Obama-Boehner deal; or (2) no deal, in which case there is no legislation before the end of the year and we “go off the fiscal cliff.” Even those who acknowledge the possibility of other legislative paths appear to treat the Obama-Boehner negotiation as if it were the only alternative to a failure to legislate.

I won’t rehash my argument that the President is no more willing to risk a no deal scenario than Republicans, and therefore that he and his advisors are bluffing when they say they are willing to “go over the cliff” if a new bill is not to their liking. But after talking to Republican friends on Capitol Hill, I am confident that I have convinced no one of this point. It appears many key Republicans believe that a no-bill scenario is unacceptable and must be avoided at any cost.

If enough Republican Members of Congress believe this, and if the President knows they believe this, then Speaker Boehner has literally zero leverage in his negotiations. The President can dictate his terms because Republicans think he is willing to walk away from a bad deal and they are not.

At the same time many conservatives on and off Capitol Hill are talking about their policy views on what a possible Obama-Boehner deal should (or even “must”) include. I hear and read that marginal rates must not increase, or that we shouldn’t raise taxes by the $1.6 trillion the President demands, or that there must be a procedural path to enact tax reform, or that the defense sequester must be mitigated, or that a deal must include significant spending cuts and entitlement reforms. While I share these policy views, it seems absurd to be simultaneously making these demands of your negotiator while giving him no leverage.

If, however, there is a third option, one that is terrible but not inconceivable, then there is at least some minimum floor to the negotiations. If a third option exists, then Speaker Boehner and the Congressional Republicans he represents can reject demands from the President that are worse than that third alternative. Even a highly undesirable third legislative option changes the negotiating dynamic, if it is minimally tolerable in the extreme. If most Republicans would prefer that third option to a no-deal “go off the cliff” scenario, then the Speaker has at least a little leverage to reject or ignore outrageous demands from the President. He can say, “No thanks, Mr. President, we’ll just go with option C, whether you want us to or not.” The negotiating term for option C is a new and stronger BATNA: Best Alternative To a Negotiated Agreement. The risk of going over the fiscal cliff is irrelevant because Republicans have a backup plan if there is no deal with the President.

This doesn’t mean Republicans want to go with option C, or that they like option C. It instead means their negotiator now has the ability to walk away from a really terrible deal with the President, and that he can therefore demand a bit more from the President in exchange for cooperation on a deal. Option C is useful to Republicans even if their strong preference, for non-policy reasons, is to negotiate a deal with the President.

I think option C is S. 3412, a bill passed by the Senate in July. The short description is that this bill “extends the middle class tax relief for one year and allows tax cuts for the rich to expire.” More precisely, here is what the bill does (Joint Tax table is here):

• It extends for one year all current income tax rates for incomes <$200K (single) and <$250K (married);
• For one year it keeps the capital gains rate at 15% for the same incomes as above;
• For one year it (explicitly) raises the capital gains and dividends rates to 20% for incomes >$200K/$250K;
• It extends for one year other provisions of current law, important and not-so-important:  marriage penalty relief and the child credit, education tax relief, and a handful of smaller provisions; and
• It patches the AMT for 2012.

There are corollary policy consequences to enacting S. 3412 as-is. Unlike the explicit capital gains and dividend rate increase on “the rich,” these consequences are implicit, meaning they would happen because S. 3412 didn’t prevent them from occurring.

• Income tax rates on incomes >$200K/$250K would increase to 36% and 39.6%, their pre-2000 rates;
• If no new legislation is enacted in 2013, we would again face the same kind of cliff at the end of tax year 2013 as we are facing now; and
• The spending sequesters would still happen beginning in January 2013, since S. 3412 is silent on the sequester.

On July 25th S. 3412 passed the Senate on a 51-48 near party line vote, in which Senators Lieberman and Webb joined all Republicans in voting no. This Senate vote is critical to my argument. Senate Democrats have already passed this bill, so it is rhetorically infeasible for them to now say no to it. If there is no Obama-Boehner deal, the Speaker has the ability to bring this bill to the House floor and present it as a take-it-or-go-off-the-cliff offer to Congressional Democrats. Many (most?) House Republicans would oppose it, but enough of them would join with Democrats to pass the bill and avert the cliff scenario.

S. 3412 is a terrible, horrible, no good, very bad bill. I hate S. 3412 because it allows taxes to increase by $80ish B (that’s a guess) next year. I hate that it raises revenues by increasing marginal rates rather than through tax reform-induced economic growth and by eliminating or scaling back tax deductions. I hate that it raises taxes on successful small business owners. I hate that it raises capital gains and dividend taxes. I hate that it creates more uncertainty and another cliff at the end of 2013. I hate that it doesn’t contain any spending cuts or entitlement reforms.

In addition I hate this bill because I helped enact, design, and defend the tax rates on income, capital gains, and dividends now in effect, first as an aide to Senate Majority Leader Trent Lott, and then as an aide to President Bush.

I detest S. 3412 and do not want it to become law.  But I fear that Congressional Republicans are so afraid of being blamed for a no-bill scenario that they will agree to support a hypothetical Obama-Boehner deal that is even worse. They should not do that. They must not do that.

If you share my policy views but think the President is not bluffing, and if you think that America cannot, under any circumstances, risk a no-bill scenario, then S. 3412 is your Option C. It does exactly what President Obama has been calling on Congress to do, it allows tax rates to increase on the rich. It just doesn’t also do other things that we know he wants to do, but which he has not been making the centerpiece of his kick-Republicans-around PR campaign. S. 3412 does not raise taxes by $1.6 trillion, but instead by $80ish B (not counting the AMT patch). It does not guarantee the President $800B – $1T over the next decade, because it tees the fight up again a year from now when the political and legislative dynamics may be different. And it does not include the debt limit increase the President is demanding in end-of-year legislation, and which if enacted now would deny Republicans a tool to demand future spending cuts.

Even more importantly, S. 3412 has passed the Senate entirely with Democratic votes and is therefore a viable legislative alternative in an endgame take-it-or-leave-it scenario. Messrs. Boehner and McConnell could, later this month, announce, “Negotiations with the President have broken down because he refused to cut spending enough. We are therefore not going to stand in the way of S. 3412 becoming law. We oppose this bill and we will both vote no. We imagine most other Republicans will do the same. But it will be brought up for a House vote, and we expect enough House Republicans will join the Democrats in voting for this policy that we will avoid an end-of-year disaster. We will oppose President Obama’s tax increases, but we will not prevent them from becoming law because we do not want to risk a recession next year. The President will get his tax increases when Democrats