WASHINGTON – The Obama administration has faced a difficult choice: Does it put off the fiscal crisis looming at the end of the year by capitulating to Republican demands to extend all the George W. Bush-era tax cuts until 2013 — a move that would infuriate the Democratic base and muddle the campaign’s message — or does it stand and fight on fiscal policy, even if that means increasing the chance that markets panic in the most crucial months for the president’s re-election bid?

On Monday, President Obama chose door No. 2, proposing a one-year extension of the cuts for families making less than $250,000 a year and, through White House press secretary Jay Carney, promising to veto any effort to “extend tax cuts for the wealthiest Americans.” It’s a strategic decision that could have a tremendous effect on the economy — and thus on the president’s chances in November.

The tax cuts dating to the Bush administration are set to expire for all income levels at the end of this year. And the debate over tax fairness has grown more pronounced with the looming deadline, this winter, of the “fiscal cliff” — a combination of mandatory spending cuts and tax increases agreed upon last year to tame the deficit that many economists believe could throw the country back into recession.

The White House and Congress have shown few signs of coming to an agreement to head off such a scenario. Republicans quickly denounced Obama’s latest proposal, arguing that it was an attempt to distract the public from the poor economy.

Extending all the Bush tax cuts and restraining the growth of the alternative minimum tax would cost about $221 billion next year, according to the nonpartisan Congressional Budget Office. Extending the cuts only for families earning less than $250,000 would cost only slightly less — around $175 billion in 2013, according to rough CBO estimates.

House GOP leaders have scheduled a July 23 vote on a one-year extension of the tax cuts for all income earners, and they charged that the president’s plan would raise taxes on small-business owners.

Technically, the economy won’t hit the fiscal cliff — Washington’s preferred term for the near-simultaneous triggering of more than $600 billion in tax increases and spending cuts, as well as the predicted point at which the country will once again hit the debt ceiling — until after the election. But the effects could be felt long before.

The 2011 debt-ceiling debate provides an illustrative example. Early that year, the recovery seemed to be proceeding smoothly. In February, the economy added 220,000 jobs. In March, 246,000 jobs. And in April, 251,000 jobs.

But as summer approached, and as markets shuddered over the Republican threat to breach the debt ceiling, the economy sputtered. Between May and August, the nation never added more than 100,000 jobs a month.

And then, in September, the month after the debt-ceiling issue was resolved, the economy sped back up and added more than 200,000 positions.

Payrolls weren’t the only evidence that the debt-ceiling fight interrupted the recovery. “High-frequency data on consumer confidence from the research company Gallup, based on surveys of 500 Americans daily, provide a good picture of the debt-ceiling debate’s impact,” economists Betsey Stevenson and Justin Wolfers observed in a column for Bloomberg View.

“Confidence began falling right around May 11, when (House Speaker John) Boehner first announced he would not support increasing the debt limit. It went into free fall as the political stalemate worsened through July. Over the entire episode, confidence declined more than it did following the collapse of Lehman Brothers Holdings Inc. in 2008. After July 31, when the deal to break the impasse was announced, consumer confidence stabilized and began a long, slow climb that brought it back to its starting point almost a year later.”

The uncertainty over the debt ceiling may not have been solely responsible for the slowdown in job creation and the drop in consumer confidence. But it surely contributed.

The 2013 fiscal cliff has the potential to be much worse than the 2011 debt-ceiling fight, if only because it includes hundreds of billions of dollars in tax increases and spending cuts. The Congressional Budget Office projects that allowing those to take effect would throw the economy back into recession — and that’s before factoring in the uncertainty about the debt ceiling.

All this is going to make businesses and investors very nervous. If they begin to expect a possible economic crisis in early 2013, they will pull back this year to cushion themselves. That could mean more layoffs and less investment in September and October — the most important months for Obama’s campaign.

In theory, the Obama administration could head this off by agreeing with Republicans to extend current policy into 2013. Republicans would have some incentive to play ball, as they also lost popularity after the debt-ceiling fight.

In addition, GOP presidential candidate Mitt Romney is facing substantial fire over his tax returns, which have highlighted the ways in which wealthy Americans can reduce their tax liability, and his tax policies, which would further cut rates on the rich.

If Obama signed the upper-income tax cuts before November, it would effectively take tax rates on the rich off the table in the election, as both parties would agree on the issue, at least through 2013. But with its announcement Monday, the Obama administration signaled that that’s not going to happen. And that means no clarity for the market on how — or whether — the fiscal cliff will be resolved until after November.

Some economists think the economy can weather the uncertainty for a while. “It’s July now, and early November is soon,” said Wolfers, a visiting professor at Princeton University. “While I can see the fiscal cliff having an effect on financial markets and on confidence fairly quickly, it’s hard to see that effect having much of an effect on the real economy prior to the election. Given that, if all you cared about were electoral math, it would make sense to go for the populist policy choice now.”

Others question whether simply putting off the hard decisions would calm the markets. “Few believe there will be any kind of progress on this or any other major fiscal issue prior to the election, (so) standing his ground through the election should do no economic harm,” said Mark Zandi, chief economist at Moody’s. “Most important, addressing the fiscal cliff (including the Bush-era tax cuts), extending the Treasury debt ceiling and laying out a credible path to fiscal sustainability should be done together. Addressing them one at a time will create more uncertainty, greater political brinksmanship, and ultimately a much worse outcome for the nation’s fiscal outlook and the economy.”

The administration is trying to defuse the economic uncertainty by simply moving forward on the policies that everyone supports. “We all say we agree that we should extend the tax cuts for 98 percent of the American people,” Obama said. “Everybody says that. The Republicans say they don’t want to raise taxes on the middle class. I don’t want to raise taxes on the middle class. So we should all agree to extend the tax cuts for the middle class.”

The calculation among Republicans is that once the middle-class tax cuts expire, they’ll lose their leverage on the upper-income tax cuts. The White House’s hope is that that answer won’t be very persuasive to voters. The GOP’s bet is that it also won’t be very comforting to the markets.

 

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