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Kimberly Amadeo

Falling Off a Fiscal Cliff

By May 28, 2012

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Will policymakers let the economy fall off the "fiscal cliff" at the end of this year? Probably not.  The fiscal cliff is when the Bush tax cuts, the 2% payroll tax holiday, and extended unemployment benefits are due to expire. In addition, the federal budget cuts mandated by the Spending Control Act are set to kick in.

If Washington doesn't take action, these changes would take $607 billion out of the economy through cutbacks in government and taxpayer spending. That would be enough of a drag to throw the economy back into recession in the first part of next year.

Would this be enough to cause a recession? It totals roughly 3.5% of total economic output, as measured by GDP, according to an analyses by JPMorgan Chase. The Congressional Budget Office estimates the economy would contract 1.5% in the first two quarters of 2013 -- the technical definition of a recession. However, economic growth would recover to a 2.3% rate in the second half, about what it is now.

If the fiscal cliff is avoided, and Congress somehow keeps all the tax cuts and ignores the spending cuts, then the CBO forecasts the economy will grow a hearty 4.4% in 2013. However, the Federal debt will continue to grow, becoming even more unsustainable.

However, a lot of political brinkmanship will occur before a resolution is finalized. The goals are the same -- no one wants another recession, and everyone wants to reduce the Federal debt -- but the two parties disagree on how to achieve it. The Democrat-led Senate wants the Bush tax cuts to expire for higher income taxpayers, and threatens to  allow billions in defense and domestic spending cuts to take place if they don't get their way.

The Republican-led House wants all the of the Bush tax cuts to be extended, and threaten to keep the debt ceiling exactly where it is now -- a replay of last year's debt ceiling crisis if Democrats don't play ball.  (Source: CNBC, "What Is This Fiscal Cliff, Anyway?" May 2, 2012; Christian Science Monitor, "Turning the Fiscal Cliff Into a Gentle Slope," May 24, 2012; Washington Times, "Congress Staring Over Edge of Fiscal Cliff", May 22, 2012 )

What It Means to You

Nothing will be done until after the Presidential election. Until then, uncertainty will sap confidence in economic growth, dragging down growth expectations. Although the economy is not likely to fall off the fiscal cliff in 2013, this drag and the one from the eurozone crisis, might be even worse.

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Comments

November 13, 2012 at 6:25 pm
(1) Michael L. Driscoll says:

$560 Billion would be taken out…immediately? In one 12 month period? In 10 years? Which is it?

November 14, 2012 at 3:36 pm
(2) useconomy says:

Hi Michael,

Actually, I was a little off. The deficit will be reduced by $560 billion. The economy will lose $607 billion — in the first nine months! Higher taxes and reduced government spending will cause a recession. This means lower income for everyone, which means lower tax revenue for the government. For an update and more detail, see What Is the Fiscal Cliff?.

Kimberly

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