Economy could handle short fall over 'cliff'

WASHINGTON -- The economic threat that's kept many Americans on edge for months is nearing reality -- unless the White House and Republicans cut a budget deal by New Year's Day.

Huge tax increases. Deep cuts in domestic and defense programs. The likelihood of sinking stock prices, reduced consumer spending and corporate layoffs. The risk of a recession within months.

Still, the start of 2013 may turn out to be far less bleak than feared. For one thing, the two sides may strike a short-term agreement before New Year's that postpones spending cuts until spring.

President Barack Obama and members of Congress return to Washington Thursday.

Even if New Year's passed with no deal, businesses and consumers would not likely panic as long as some agreement seemed imminent. The $671 billion in tax increases and spending cuts could be retroactively repealed.

And the impact of the tax increases would be felt only gradually. Most people would receive slightly less money in each paycheck.

"The simple conclusion that going off the cliff necessarily means a recession next year is wrong," said Lewis Alexander, an economist at Nomura Securities. "It will ultimately depend on how long the policies are in place."

It's always possible that negotiations between President Obama and Republican congressional leaders will collapse in acrimony. The prospect of permanent tax increases and spending cuts could cause many consumers and businesses to delay spending, hiring or expanding.

Without any agreement at all for months, the fiscal cliff would cause the U.S. economy to shrink 0.5 percent in the first half of 2013 and fall into recession, the Congressional Budget Office estimates.

But most economists expect a deal, if not by New Year's then soon after. Businesses and consumers will likely remain calm as long as negotiators seem to be moving toward an agreement.

"The atmosphere is more important than whether the talks spill" into next year, said Paul Ashworth, an economist at Capital Economics.

Optimism

Here's why many are optimistic that a brief fall over the cliff wouldn't derail the economic recovery:

* Though the fiscal cliff would boost taxes by $586 billion for all of 2013, the tax hit for most people would be modest at first. The expiration of Social Security and income tax cuts would be spread throughout 2013. For taxpayers with incomes of $40,000 to $65,000, paychecks would shrink an average of about $1,500 next year. That would be a significant bite over the full year, but the initial hit would be just $130 in January, according to the nonpartisan Tax Policy Center.

* About a third of the tax increases wouldn't touch most Americans. Some would hit businesses. Others, such as higher taxes on investment income and estates, and the expiration of middle-income tax credits, wouldn't come due until Americans filed their 2013 taxes in 2014.

* The Internal Revenue Service has delayed any increases in tax withholding that would otherwise kick in. Without a deal, the top income tax rate for single people with taxable income between about $36,000 and $88,000 would rise from 25 percent to 28 percent. But that won't start to reduce Americans' paychecks in early January, even if no deal is reached by then.

* About $85 billion in spending cuts to defense and domestic programs would take weeks or longer to take effect. That means government agencies wouldn't cut jobs right away.

If a short-term agreement is struck, some taxes would probably still go up. These would include a 2 percentage point cut in Social Security taxes that's been in place for two years. Its expiration would cost the typical household about $1,000 a year. With income gains sluggish, that could dampen consumer spending.

Pessimism

A temporary deal that delays some hard decisions could reduce business and consumer confidence. It would also mean:

* Extended unemployment benefits would end for 2 million people. The federal government's program pays for about 32 weeks of extra benefits, on average, on top of the 26 weeks most states provide. Weekly unemployment checks average about $320 nationwide.

* The stock market would probably drop, though maybe not by much. Many Wall Street analysts expect a partial deal of some kind. "There is starting to become a little bit of an acceptance that we fall off the fiscal cliff," said J.J. Kinahan, a strategist for TD Ameritrade.

* The expiration of the Social Security tax cut and the end of emergency unemployment benefits would likely shave 0.7 percentage point off economic growth next year, the CBO estimates. The economy is now growing at about a 2 percent annual pace.

If no deal at all was reached by January and budget talks drag on, many businesses might put off investment or hiring. That's why most economists say it would be crucial to reach a deal within roughly the first two months of 2013.

In addition, many more people would be affected if something called the alternative minimum tax isn't fixed.

The financially painful AMT was designed to prevent rich people from exploiting loopholes and deductions to avoid any income tax. But the AMT wasn't indexed for inflation, so it has increasingly threatened middle-income taxpayers. Congress has acted each year for a decade to prevent the AMT from hitting many more people.

If it isn't fixed again, roughly 33 million taxpayers, including married couples with income as low as $45,000 -- down from $74,450 in 2011 -- could face the AMT. Previously, only 5 million taxpayers had to pay it. Taxpayers subject to the AMT must calculate their tax under both the regular system and the AMT and pay the larger amount. Without a fix, a middle-income household would pay an average of $1,231 more, according to the Tax Policy Center.

The IRS has said it assumes Congress and the White House will fix the AMT in a deal to avoid the cliff. If they don't, the IRS will need weeks to reprogram computers and make other adjustments. In the meantime, about 100 million taxpayers couldn't file tax returns early next year because they couldn't determine whether they owe the AMT. Refunds would be delayed.

The gravest scenario would be if the budget talks collapsed and the tax increases and spending cuts appeared to be permanent.

In that case, Macroeconomic Advisors warns that the Dow could plunge up to 2,000 points within days. Businesses would turn gloomier in anticipation of Americans paying higher taxes and spending less.

The economy would shrink at an annual rate of 0.6 percent in the first three months of 2013, estimates Joel Prakken, an economist at Macroeconomic Advisors. That compares with an estimated 1.9 percent growth rate if a deal is reached. CBO forecasts that the unemployment rate would rise to 9.1 percent from the current 7.7 percent.

Last week, Obama and House Speaker John Boehner narrowed their differences on income tax increases and spending cuts. But with the two sides deadlocked, Boehner scheduled a vote on a bill to prevent taxes from rising on those earning less than $1 million a year. Opposition from anti-tax conservatives, and Democrats, forced him to cancel the vote.

The gridlock caused stocks to fall Friday. The Dow Jones industrial average dropped 121 points.

Obama called for a vote on a stripped-down agreement that would raise taxes only on the wealthiest 2 percent of Americans and extend emergency unemployment benefits. Automatic spending cuts would be postponed.

Whatever the outcome, some trends could offset part of the economic damage. The average retail price for gasoline has dropped 15 percent this fall, for example. Lower gas prices give consumers more money to spend elsewhere.

And if the crisis is resolved, as many expect, the boost to business and consumer confidence would encourage more hiring and spending.

"We could end up with a much more robust recovery than anybody's envisioned" if a deal is reached, said David Cote, CEO of Honeywell International.

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AP Business Writers Christina Rexrode, Steve Rothwell and Daniel Wagner contributed to this report. Rexrode and Rothwell reported from New York.

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