The 2012 tax and spending wars

You thought the payroll tax cut fight twisted Congress in knots. Wait until next year's battles over the Bush tax cuts.

NEW YORK (CNNMoney) -- Congress couldn't agree how to pay for a year-long extension of the payroll tax cut, federal unemployment benefits and an adjustment in Medicare physician pay.

In fact, it could barely agree on whether to extend them for two months.

And all three are relatively minor measures in the context of all the budget issues Congress has to address.

So imagine how much fun this Congress will have this time next year when two legitimately big issues will be at hand: The nearly $4 trillion Bush-era tax cuts, which will be set to expire, and roughly $1 trillion in automatic spending cuts, which will be poised to take effect.

Coloring their decisions, of course, will be two unpredictable factors: The state of the economy and who wins control of the House, the Senate and, of course, the White House.

That's why longtime budget expert Stan Collender wouldn't be surprised if the lameduck Congress next year just decides to punt to the next Congress, temporarily extending the tax cuts and delaying the spending cuts.

What the payroll tax cut deal will do

But no one should be surprised if they fight bitterly about it up until and possibly right through Christmas.

Bush-era tax cuts: If Congress does nothing, the 2001, 2003 and 2006 tax cuts will expire at the end of December 2012.

If they do expire, most Americans' tax bills would go up and the surge of additional revenue into federal coffers would greatly improve the deficit picture over the next decade.

But many worry the overnight jump in taxes could hurt the economy if it's still weak. And others say higher rates across the board is not the most efficient way of reducing deficits.

In any case, most Republicans want to make the tax cuts permanent while many Democrats want to make them permanent for everyone except high-income households.

If all the cuts are extended, they could reduce revenues by an estimated $3.7 trillion over a decade. If only most of them are extended, that would reduce revenues by about $3 trillion.

In theory, Congress could use 2012 to hammer out a deal on tax reform -- which, done right, would make the Bush tax cut issue null and void. But most tax policy experts don't expect lawmakers to lock arms on a complete tax code overhaul before 2013 at the earliest.

Indeed, given how the partisan divide over the Bush tax cuts helped derail the super committee, the road to real tax reform might take awhile.

Automatic spending cuts: Since the super committee failed to strike a deal on anything, the Budget Control Act passed in August calls for automatic spending cuts starting on Jan. 2, 2013 to reduce deficits by $1.2 trillion over nine years.

Those cuts would be divided evenly between defense and nondefense spending, although key programs for low-income Americans would be exempt.

The debt committee called it quits right before Thanksgiving. That gives lawmakers all of 2012 to ward off the cuts if they want to. And many do, particularly Republicans and some Democrats who worry about the effect the cuts might have on U.S. defense.

But ratings agencies have made clear it would be a negative for the U.S. credit rating if lawmakers simply canceled some of the cuts and didn't offset them with other budget cuts.

Of course, Congress could choose to use the next year to hammer out a bipartisan debt reduction plan worth $1.2 trillion or more. Or they could choose not to.

It is likely, in any case, that President Obama may push for a "grand bargain" deal when he proffers his 2013 budget proposal to lawmakers in February.

"I expect a go-big, $3 trillion to $4 trillion deficit reduction plan," Collender said.

As with most presidential budget proposals, however, Congress won't adopt it in whole, or even necessarily in part.