GOP 'Doomsday' Scenario - A Strategic Retreat?

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Republicans are divided. President Obama won't budge. And more and more, it looks like the fiscal-cliff deadline of December 31 will be missed.

It's now clear that Team Obama wants higher tax rates and revenue-raising tax-deduction caps to meet their $1.6 trillion revenue target. Spending cuts and entitlement reforms are vague to non-existent. In fact, it could be that Obama not only rejects the across-the-board budget sequester, but that he actively seeks to raise spending, not cut it.

I guess it stands to reason that if you puff up his $800 billion revenue increase from last year, and double it to $1.6 trillion this year, the money will be spent. The government will grow larger.

All this should be unacceptable to the GOP.

(Read More: Boehner: Obama Walking Economy to Edge of 'Cliff')

Senator Rand Paul, who may have the best idea, told me in an interview this week that he's prepared to pin the tail on Obama's tax-and-spend donkey. "In the Senate," Paul said, "I'm happy not to filibuster it, and I will announce tonight on your show that I will work with Harry Reid to let him pass his big old tax hike, with a simple majority, if that's what Harry Reid wants, because then they will become the party of high taxes, and they can own it."

Other conservatives in the Senate and House agree with Mr. Paul. And some House members are talking about a "doomsday" scenario, or what might be called a strategic retreat. Just vote present on the Democrats' tax bill to extend middle-class tax cuts and raise tax rates on income and investment.

A couple dozen other Republicans have signed a bipartisan letter suggesting flexibility on tax rates in return for some kind of entitlement reform --perhaps moving the top rate from 36 percent to 37 or 38 percent, less than the 39.6 percent Clinton rate, and possibly raising the so-called rich people's threshold to $500,000 or $700,000 from $250,000. But with a vague and un-budging Team Obama, this sounds like a triumph of hope over experience.

(Read More: Who's to Blame If 'Cliff' Talks Fail?)

The most valiant guy in this process is Speaker John Boehner. He's still trying to cut a deal that would extend all marginal tax rates, including for the upper brackets (he is absolutely determined to prevent an increase in top marginal tax rates, which would really damage the economy), in return for a cap on tax deductions. That would raise roughly $800 billion in revenues, hitting upper-end taxpayers but leaving the middle class alone. It's like a halfway tax reform, since marginal rates would not be flattened. But it would do less harm to the economy because tax-rate incentives necessary for growth would not be damaged.

The Boehner plan has stalled. And some conservatives are criticizing the speaker for permitting any tax hikes at all. In an anemic recovery,transferring $800 billion in revenues from private hands to the government will do some damage.

Of course, Boehner is trying to leverage this for significant spending cuts and entitlement reforms. It's a worthy objective, but he's just not making headway.

Conservatives shouldn't be so hard on Boehner. He's trying to deal with post-election realities and sincerely believes voters want a compromise. Worth noting, prominent conservative House leaders, like Eric Cantor, Kevin McCarthy,and Paul Ryan, are standing behind Boehner.

(Read More: Obama: 'We Can Probably Solve This in a Week')

On the other hand, senior House leadership aides are not happy with Senate Harry Reid are ready to do a two-stage deal if the Boehner-Obama talks collapse. The first stage would extend middle-class tax rates and some how compromise on upper-end rates. Then a process would be set up to produce spending cuts to replace the sequester. But House aides regard this as a nonstarter, one that could even undermine the Boehner-Obama talks.

Here's the really big principle in all this: Why raise taxes at all in the worst economic recovery going back to 1947? Tax hikes and larger government are economic deterrents.

Furthermore, the whole world is talking taxes rather than spending cuts. What happened to the $1.2 trillion sequester? And what happened to the idea of $4 of spending cuts for every $1 of tax revenues? Some scorekeepers believe Obama's plan raises taxes more than it cuts spending. Not exactly what Simpson-Bowles had in mind. Or even Ronald Reagan, who back in 1982 was promised three-to-one spending cuts over revenue increases. He didn't remotely get it.

As an old Reagan supply-sider who believes in the flat tax and strictly limited government, none of this makes sense in terms of promoting economic growth,jobs, and prosperity. But the key tactical point is that all these machinations seem unlikely to meet the December 31 deadline for tax extensions and sequester budget cuts.

That may not be the end of the world. But it shows how dysfunctional Washington remains.

(Read More: We'll Fall Off 'Cliff' If Tax Rates Don't Rise: Geithner)

—By CNBC's Larry Kudlow; Follow him on Twitter @larry_kudlow