A critical vote on tax cuts and unemployment insurance benefits is coming up in the lame-duck session.

The president wants middle-income tax cuts extended, but he wants tax cuts for those making over $250K to expire. The Republicans have generally said “all or nothing”.

Unless Congress acts, consulting firm Deloitte Tax LLP estimates the tax bill for a family earning $70,000 would rise by about $2,600. Moreover, tax rates on dividends and capital gains will go up, as will federal taxes on estates worth over $1 million.

All or Nothing?

It’s very difficult to believe Republicans would throw everything down the toilet if they do not get tax cuts extended for those making over $250,000.

Moreover, Democrats want a number of things Republicans don’t, such as unemployment insurance. This creates bargaining opportunities on both sides.

The Unemployment Benefits Bargaining Chip

Unemployment benefits for roughly 2 million unemployed are about to expire. That so many have used up 100 weeks of benefits is a testament to the length and severity of the recession.

It’s the Democrats who want to extend unemployment benefits, not the Republicans.

This bargaining chip is why I have said on a couple of occasions that I expect a deal: Republicans will get their tax breaks while the Democrats get unemployment insurance extended yet again.

A Test of Mettle

With that backdrop, please consider Democrats to Test Republican Mettle With Tax-Cut Vote

U.S. House Speaker Nancy Pelosi will schedule a vote this week on legislation that would retain lower tax rates and increased credits that apply to the first $250,000 of a married couple’s gross income or $200,000 for a single person, said her assistant, Maryland Democrat Chris Van Hollen.

“There should be an early vote on middle-income tax cuts” before the Senate considers alternatives on Bush-era tax cuts set to expire on Dec. 31, said Baucus, a Montana Democrat. The vote’s timing will depend on the rest of the Senate’s agenda, he said.

Extending the tax cuts permanently would cost the government $5 trillion in revenue and interest on the debt over the next decade, the Congressional Research Service estimated in October.

Failure to extend all the tax cuts would subtract 1 percentage point from growth in the gross domestic product, according to an estimate released in November by Barclays Capital, reducing projected growth in 2011 from 2.8 percent to 1.8 percent, with “sharply lower growth” in the first quarter.

Senator Dick Durbin of Illinois, the senate’s No. 2 Democrat, said negotiations over extending the tax cuts also will include prolonging emergency unemployment benefits and other tax credits.

“I want to put a couple other things on the table,” Durbin said today on NBC’s “Meet the Press” on Nov. 28. “We do have unemployment running out,” and “I also want to make sure the earned-income tax credit, the childcare tax credit, and the ‘Making Work Pay’ tax credit are part” of the discussion.

Divide and Conquer

The Democrat strategy is to divide and conquer. Dare the Republicans to veto middle-income tax cuts, while delaying votes on everything else.

Will divide and conquer work?

With procedural issues in the Senate the overriding factor, the question comes down to which party would get most of the blame if nothing passes. Sadly, that’s what’s become of politics.

There are several of ways this could progress:

1. Congress passes a bloated, unaffordable bill with every favor either side wants
2. Nothing passes at all
3. Something in between.

Let’s assess the odds of each scenario.

The Bloated, Unaffordable Option

Senator Durbin may cave into Republican wishes as long as he gets everything he wants (earned-income tax credit, the childcare tax credit, the ‘Making Work Pay’ credit, and and extension of unemployment benefits).

Should that happen, expect one hell of a bloated tax bill which would prove the Republicans are hypocrites about reducing the deficit. It would also test Obama’s mettle given that he has stated the country can’t afford to borrow $700 billion to extend lower tax rates for top earners.

Would the president then veto the legislation?

I doubt it, and that would make Obama a hypocrite for signing the bill and the Republicans hypocrites for passing it. Unfortunately, neither side really cares about the “hypocrites label” given that hypocrisy is an everyday occurrence in both parties.

Thus, I believe passage of a bloated bill that both sides agree we cannot afford is the most likely possibility. Assume something like a 45% chance.

The Nothing Passes Option

It is certainly possible that nothing gets passed because of Senate infighting. Should that prove to be the case, it would be a forerunner of something that is all but guaranteed to happen in the next Congress.

If “nothing passes” expect a huge jump in bankruptcies and foreclosures and the economy to veer back towards recession, with everyone pointing the finger at everyone else.

Also expect Bernanke to go ape-sheet in unpredictable ways.

Bear in mind a huge jump in bankruptcies and foreclosures my be coming anyway, but passing noting will provide the opportunity for more political finger-pointing.

I rate “nothing passes” as the least likely possibility with something like a 15% chance.

The In-Between Scenario

In-between covers so much ground that it’s hard to address every case. Should this happen, I would think it would be closer to the “one hell of a bloated bill” than not.

If so, the likely compromise would be extending most of the tax cuts but capping them at $350,000 or $500,000 instead of $250,000. In return, look for scrapping the ‘Making Work Pay’ credit, and a minimum extension to the number of weeks of unemployment insurance coverage.

I have the odds of this at roughly 40%, not much different than the odds that “one hell of a bloated bill” passes.

Depending on the exact nature of the compromises, this could be an extremely bloated bill as well.

Looking Ahead To 2011

Don’t expect unemployment insurance extensions next year, don’t expect cap-and-trade, and in fact don’t expect much of anything other than gridlock and for Congress to pester Bernanke.

Whatever passes in this lame-duck session (if anything) could easily be it.

If banks get into trouble again (as is highly likely), bailouts discussions will be dead-on-arrival.

Bernanke needs help from Congress to continue his misguided reflation efforts, and he has even admitted as much. I doubt that help is coming.

Mike “Mish” Shedlock
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