Congress's failure to reach a fiscal "grand bargain" last summer manifested the deep economic-policy divide separating Democrats and Republicans. Fortunately, the so-called fiscal cliff will soon create an extraordinary second opportunity for a breakthrough compromise.
Washington's continued failure to get our fiscal house in order poses five basic risks. One, government borrowing risks crowding out private investment. Two, our unsustainable fiscal outlook undermines business confidence by creating uncertainty about future policy, economic conditions and our ability to govern, which in turn dampens investment and hiring.
Three, deficits constrain our capacity to make the public investment critical to competitiveness, growth and widespread income gains. Four, deficits hamper our financial ability to cope with economic weakness or geopolitical events. And five, our fiscal position creates a strong potential for some form of severe macroeconomic distress at an unpredictable time: high inflation, high interest rates and low confidence in the future that produce an extended period of slow or negative growth, or a harsh financial crisis.
Soon after November's election several events will put serious pressure on both parties, possibly providing the impetus for a serious fiscal program. The critical decision-making period will be Congress's lame-duck session after the election, and the first two or three months of the new Congress.
These events are already understood: The 2001 and 2003 tax cuts for middle-class and upper-income taxpayers, and the payroll tax holiday, will expire at the end of 2012. The dramatic mandatory reduction in spending ("sequestration") required by last year's debt-ceiling deal will take place in January 2013. And the debt ceiling will need to be raised again in late 2012 or early 2013.
Each of these events is unacceptable for one or both political parties. Sequestration includes deep cuts to nondefense spending that Democrats oppose, and similarly deep cuts to military spending that make Republicans (and many Democrats) recoil. Republicans oppose the expiration of tax cuts on upper-income Americans, Democrats oppose the expiration of the payroll tax holiday, and members of both parties oppose the expiration of middle-class tax cuts.
As for the debt ceiling, the party in the White House will insist that it be raised (because there is no other responsible choice), while the other party may seek to use it as leverage to achieve other policy goals, as we have seen before.
Since some form of divided government after the election is likely, the parties will need to make an accommodation with each other to avoid chaos. Even if one party controls the White House and Congress, it might still seek meaningful bipartisan participation to avoid sole responsibility for difficult decisions. The multitrillion-dollar question is what kind of accommodation it will be.
There is widespread concern about our elected officials' willingness to find common ground on tough issues. When the right choice is the tough choice, it can be all too easy to make the wrong one. Many experienced people think that will happen, with the parties agreeing to kick the hardest choices down the road by extending the tax cuts, canceling the sequester, raising the debt limit and resolving to "study" the problem.
But this time could possibly be different, thanks to five factors combining to create the best political environment for real fiscal action in a long time. The risks of inaction are apparent and will put pressure on all policy makers: Sequestration and expiring tax cuts will have severe consequences and could cost the country 3.5%-4% of gross domestic product in 2013. A political punt would be a striking manifestation of our inability to govern ourselves and could heighten uncertainty and lack of confidence about future economic policy. That could have serious adverse impact on our economy and on markets. And the months right after a presidential election are—since they're the furthest from the next federal elections—the lowest-pressure time in our political system.
Most important, there is no choice available to Congress that does not involve significant changes to taxes and spending that members of each party will oppose. Unlike any situation I remember, Congress cannot simply maintain the status quo by failing to act.
Doing nothing means tax increases and massive cuts in defense and nondefense spending. Kicking the can down the road requires compromising with the other party on taxes and spending. And biting the bullet on the hard choices will necessitate compromises and action as well. The compromises required for constructive action are substantially harder than the compromises necessary to punt, but taking the easy way out requires actions that come with their own set of political costs. And, the longer you avoid tough choices, the deeper the hole gets, the greater the resulting crisis is and the harsher the necessary measures necessary to reestablish confidence and recover.
What's more, most policy analysts agree on the basic framework for establishing sound fiscal conditions, though the specifics would require intense negotiation.
The overarching goal should be a 10-to-12 year track of deficit reduction that stabilizes the ratio of debt to GDP and then begins to bring it down. Within that context, we must create budgetary room for vigorous public investment in education, basic research infrastructure and other areas that are critical for competitiveness and broad increases in standards of living.
Reducing the deficit, increasing public investment, and preserving government's ability to conduct critical activities will require constraints on spending in all areas, including serious entitlement reform, substantial additional revenues, and difficult judgments on priorities and trade-offs. Because the recovery is still relatively fragile, implementation of the deficit-reduction package should be deferred for a time certain—say, two years—to give the recovery additional time to take hold. But that implementation must be made difficult to cancel or delay, so that it is understood as credible.
There will be vigorous debate about how to raise revenues. I believe the three principal criteria should be economic impact, fiscal effect and progressivity. We should increase the top rate, reform the alternative minimum tax to create greater fairness without penalizing the middle class, and increase capital gains and dividend taxes to levels that best satisfy those criteria. There are also opportunities presented by revising tax credits and deductions, but the impacts are complicated and the potential may be limited.
Whatever the outcome of the elections in November, our political leaders will encounter an extraordinary set of circumstances that we are unlikely to see again. Those circumstances will create a historic opportunity to reshape America's long-term economic outlook for the better. Let's hope they take it.
Mr. Rubin, a former U.S. Treasury secretary, is co-chairman of the Council on Foreign Relations.
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