Fiscal Cliff

The fiscal cliff is a combination of four tax increases and two spending cuts that are scheduled to automatically take place on January 1, 2013. The tax increases occur when the Bush tax cuts, the 2% payroll tax holiday and the extension of the alternative minimum tax waiver all expire on December 31, 2012. When the Bush tax cuts expires, the tax rates will increase as follows:

• Income taxes: revert to Clinton-era rates.
• Capital gains tax: from 15% to 20%.
• Dividend taxes: from 15% to more than 43%.
• Estate taxes: from 35% to 55%, depending on the size of the estate.

Investors also avoided a potential 3.8% hike on capital gains and dividends as a result of Obamacare taxes.(Source: CNBC, Wealthy Dump Assets, November 12, 2012)

The expiration of the payroll tax cut means workers will see an additional 2% taken out of the paycheck to go toward Social Security. Without a waiver, the alternative minimum tax will apply to 21 million more workers, making as little as $50,000 a year.

The next day, the Obamacare taxes kick in. This is additional income and investment taxes on family incomes above $250,000. The spending cuts occur when the extended unemployment benefits expire and an across-the-board 10% Federal budget cut kicks in.

It's called a fiscal cliff because Federal taxes and spending are managed by fiscal policy. It's a cliff because the effect of increased taxes and decreased spending happening at once is like pushing the economy off a cliff.

The term was coined by Federal Reserve Chairman Ben Bernanke in February 2012 when he warned the House Financial Services Committee,"Under current law, on Jan. 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases..." (Source: The Hill, Bernanke Warns of Massive Fiscal Cliff, February 29, 2012)

However, the term "fiscal cliff" has been in use since 1987, when the Boston Globe used it to describe a local utility's financial situation. It was used again in 1991 by California Representative Henry Waxman, referring to Oregon's budget. (Source: Oxford Dictionary)

The fiscal cliff negotiations became a critical issue after the 2012 Presidential election. First President Obama developed a plan A, then House Speaker Boehner responded with a Plan B. Uncertainty around the outcome kept economic growth lower than needed to reduce unemployment. That's because most businesses had to be conservative, and follow operational plans that included the fiscal cliff scenario. For more, see Fiscal Cliff 2012.

What happens in 2013 if nothing is done? Here's some of the major changes:

• On average, taxes will go up $2,000 to $3,000 per household.
• Around 26 million taxpayers will become eligible to pay the Alternative Minimum tax, originally set up to capture wealthy tax dodgers. However, since it wasn't indexed for inflation, it will raise taxes for many middle income taxpayers by as much as $3,700.
• Roughly two million jobseekers will lose extended unemployment benefits.
• There will be a $55 billion cut in military spending, resulting in temporary job losses.
• Most other departments will be cut 8%. This includes aid to states, highway construction and the FBI. (Source: CNBC, Cliff Plunge: All But Impossible to Avoid the Pain, November 13, 2012; Forbes, The Fiscal Cliff Explained, November 10, 2012)

To make matters worse, Federal spending is likely to exceed the debt ceiling, currently at $16.394 trillion, early in 2013. If Congress doesn't raise the ceiling, the nation will go into a debt default. President Obama tried to make raising the debt ceiling part of the fiscal cliff negotiations. For updates, see Fiscal Cliff 2013.

The tax hikes and spending cuts would remove $607 billion from the economy in the first nine months of 2013 (that's the remainder of the 2013 Fiscal Year), according to the Congressional Budget Office.

Although it's good long-term to reduce the deficit, in the short term it will severely retard economic growth. That's because government spending is an important component of the Gross Domestic Product (GDP). Suddenly cutting it by 10% or so would mean broken contracts with businesses, fewer government jobs and reductions in benefits.

The tax increases would reduce consumer spending by that amount. The net effect, according to the CBO, would be a 1.3% contraction in the economy for the first half of the year. In other words, a recession. Although the economy would recover in the second half, the growth would be anemic -- barely 2%, or the low end of a healthy economy. Most legislators agree that this can't be allowed to happen.

The fiscal cliff has already affected you by slowing economic growth. As a result of the impending uncertainty, businesses have postponed hiring and expansion. This makes it harder for the unemployed to find a good job.

In 2013, if nothing is done, the economy will go back into recession. That means you might lose your job, especially if you just got it, as businesses tend to lay off the most recently hired first.

The fiscal cliff will impact some more than others. The long-term unemployed will lose their extended benefits. Everyone will have to pay more in payroll and income taxes. Those dependent on government contracts may lose the Federal government as a customer, while Federal employees may get laid off.

In 2011, the President and a Democrat-controlled Senate disagreed with the Republican-controlled House on the the best ways to reduce the deficit and debt. As government spending approached the debt ceiling, both parties finally agreed to appoint a bipartisan commission to propose a solution. The subsequent Simpson-Bowles Report was, unfortunately, ignored. Instead, Congress passed the Budget Control Act, which mandated a 10% spending cut. This was intended to be so severe that it would force Congress to act.

The impasse was basically in three main areas:

1. The Democrats refused to extend the Bush tax cuts for families making $250,000 or more. The Republicans refused to extend the tax cuts for anyone if everyone can't have them.
2. The Democrats would rather cut more out of defense spending, while the Republicans would rather cut Social Security, Medicaid and Medicare.
3. In addition, the Republicans want to repeal the Obamacare taxes.

This standoff was a little bit of political posturing in advance of the 2012 Presidential election. With that behind us, it looks more hopeful that both parties will find enough of a common ground to avoid falling off the fiscal cliff and plunging the economy into recession.Article updated December 23, 2012