Eye on the 'Fiscal Cliff': Is President Obama's Proposal a Deal-Breaker?

"The debate looks to be about higher revenues and rates, not a true compromise, and Republicans are getting boxed in."

[Editor’s note: The following is a cross post by Larry Kudlow that originally appeared on CNBC.com]:

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Right after the election, it was all peaches and cream and conciliatory common-ground language when President Barack Obama met with congressional leaders to discuss the "fiscal cliff."

Of course, the president campaigned on tax hikes for the rich, by which he meant raising top income-tax rates and extending the Bush tax cuts for incomes below $200,000.

And the president’s first meeting post-election was with his union and liberal-interest-group supporters, all of whom want to raise the top rates and then some. But instead, the newly re-elected president spoke about “new ideas,” as long as they provided a balance of spending cuts and tax increases on the most successful upper-end earners.

Now, however, a stalemate may be just as likely as solution. Why?

Well, it was former Bush advisor Keith Hennessey who discovered a big obstacle in all this. Team Obama wants a gargantuan $1.6 trillion tax hike over the next ten years to finance larger government. And Hennessey surmised -- and I agree -- that the reason the president couched his language in terms of higher tax “revenues” rather than tax “rates” is that he essentially wants both. Raise the top rates and cap or eliminate a number of tax deductions for more revenues.

This is going to be a big problem. It could well be a deal-breaker.

House Speaker John Boehner has been pressing for a quasi tax reform, which may be the best Republicans can get. Namely, leave the tax rates alone and put a Mitt Romney-like cap on so-called tax loopholes that mainly concern upper-end earners.

This Republican revenue concession would at least preserve economic-growth tax incentives. Yes, it would transfer $1.3 trillion from the private sector to government hands, a huge anti-growth transfer of resources. But at least the Boehner plan leaves tax rates unchanged.

However, raising the two top rates would only produce about $440 billion, which is way below Obama’s $1.6 trillion number. So you can almost sense that the president is going to go for higher tax rates, strict limits on itemized deductions, a phase-out of the personal exemption, and tax-rate hikes on capital gains, dividends, and estates.

On top of all that, the Financial Times reports that Team Obama wants a $150 billion business tax hike over ten years.

Sooner or later this is the Obama agenda. And it’s going to be a big stumbling block for a year-end deal that would avoid a roughly $450 billion tax hike that would sink us back into recession.

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New reports suggest there’s no progress between the White House and Republican congressional leaders. No wonder. The debate looks to be about higher revenues and rates, not a true compromise, and Republicans are getting boxed in.

None of this revenue transfer to the government is remotely pro-growth. And hiking taxes on capital gains and dividends is significantly anti-growth. With Obamacare taxes, the 15 percent cap-gains tax could run up to 23.8 percent and the 15 percent dividend rate could jump to 43.4 percent. And that doesn’t even include the integrated corporate tax rate.

So here’s the economic-growth problem: The after-tax-incentive return on cap-gains would fall more than 10 percent. On dividends it would drop over 33 percent. (Interestingly, over 100 large companies have declared special dividends to beat a year-end tax hike.) This raises the cost of capital and lowers the return on investment for the entire economy.

By making capital less valuable and more expensive, you get less of it. And you can’t have entrepreneurial capitalism without capital. Higher capital costs block business formation, productivity, jobs, and incomes.

Frankly, in terms of long-run economic growth, taxes on capital investment are more important than income taxes. On top of that, every time the capital-gains tax rate is raised, it generates lower long-run revenues. But if you cut the rate, revenues soar. Just ask Bill Clinton, whose second-term capital-gains tax cut led to a budget surplus.

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And nobody is even talking about spending. The original across-the-board sequester, which was supposed to slash $1.2 trillion from the budget, is off the table. Apparently, $50 billion is the new number. So let me get this right: A $500 billion tax hike, and a $50 billion spending cut. That’s revenues-over-spending by ten-to-one. Wasn’t Simpson-Bowles looking for $3 or $4 in spending cuts for every $1 of new revenues?

So, it looks like way too many tax hikes, way too few spending cuts, and a big anti-growth fiscal package that is more like European-style austerity than American-style, free-enterprise recovery. This is why the stock markets are so nervous. They don’t know what they’re gonna’ get.

Right now, stalemate is just as likely as solution.

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