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What is the Fiscal Cliff?

You have may heard a lot of talk lately about this “fiscal cliff.” It refers to yet another battle over the debt ceiling, a lot of automatic cuts and tax law expirations, and generally a “perfect storm” of fiscal policy that paints a bad economic picture. Coupled with all the political fighting, a Presidential election, and you have yourself a bad scenario with a potentially bad outcome.

They call it a fiscal cliff because fiscal policy refers to using taxation and spending to influence the economy (as opposed to monetary policy, which uses the monetary supply to influence the economy) and all of these problems are fiscal problems. They’re the result of politicians kicking the proverbial can down the road, implementing extensions rather than making a decision for the future. I don’t blame them, it’s hard to make these decisions and get them passed in such a partisan environment.

But that doesn’t help us understand what it is. Here’s the fiscal cliff, as I understand it:

Bush Tax Cuts Expiring

You may remember a couple years ago when we first talked about the expiration of the Bush tax cuts. If you’re math is as good as mine, it looks like our two year extension is up but this time President Obama has stated that he will not extend it to families earning $250,000 or more. Senate Democrats aren’t sure if they want that target income to be $1 million or $250,000. Either way, tax rates [3] would be set to go up significantly if nothing were done.

Lastly, there are around 50 “temporary” tax breaks (the term temporary is always up for debate with Congress!) for businesses and individuals that would expire and have varying effects on taxpayers. The most notable is a fix to the Alternative Minimum Tax (AMT) fix that would be removed, which is estimated to cost the average taxpayer about $3,000 (according to the Tax Policy Center).

On a smaller note, the payroll tax cut [4] is also expiring this year. You may not have noticed it but instead of paying 6.2% to Social Security and Medicare, you were only paying 4.2%, a reduction of 200 basis points. The payroll tax cut was extended by the Middle Class Tax Relief and Job Creation Act of 2012, but that piece expires at the end of the year.

Debt Ceiling Looming

Didn’t it seem like we were talking about the debt ceiling just a year ago? That’s because we were. 2011 was marked by a lot of political battles over the debt ceiling as Republicans took control of the House while Democrats retained control of the Senate. The limit of $14.29 trilling was reached in May 2011 but the Treasury was able to extend government services until August 2nd. An agreement was reached, a piece of which we’ll discuss shortly, to increase it to $15.2 trillion just a few days before we’d hit the ceiling. That limit increased again to $16.4 trillion in January of this year, but we’ll hit that limit at the conclusion of 2012 (though the Treasury says it can extend it into early 2013).

Automatic Spending Cuts

As part of the debt ceiling deal reached last year, both parties agreed to a set level of discretionary spending for 2013 at $1.047 trillion. This would exclude programs like Medicare and Social Security. If that holds, it’s a cut of $97 billion in spending, half coming from defense. That’s a 10% cut in defense, 8% from non-defense discretionary, though how those cuts would be implemented are not yet known. The cuts would continue to the tune of $1.3 trillion over ten years. Unless something is done, these cuts are automatic and could send reverberations throughout the economy as it would invariably result in a loss of jobs.

What’s the impact of all this? The Congressional Budget Office estimates that if nothing is done, the economy would shrink by 1.3% for the first half of 2013. Not fun.

(Photo: aussiegall [5])