What is the Fiscal Cliff?

what-is-the-fiscal-cliff_blog_staff-management-SMXMany of you may have been reading “fiscal cliff” in the headlines over the past couple of month or so. Although this term encompasses a variety of complex issues, in a nutshell, the fiscal cliff is used to describe a bundle of significant U.S. federal tax increases and spending cuts that are set to take place towards the end of 2012 and beginning of 2013. According to recent Congressional Budget Office (CBO) projections, these measures are supposed to reduce the federal budget deficit by $503 billion between fiscal year 2012 and fiscal year 2013. Without legislative intervention, these strict budgetary measures have led economists to fear a double-dip recession and an increase in unemployment in the coming year. While inaction by Congress can have negative economic effects, abolishing all of the planned measures without constructing a long-term deficit deal can also be hazardous to the U.S. economy.

Components of the Fiscal Cliff

There are three main components of the fiscal cliff, revenue increases, spending cuts and the debt ceiling. The 2001/2003/2010 Tax Cuts and AMT Patch, also known as, “Bush tax cuts,” expire on December 31 and will raise all income tax along with rates on estate and capital gains taxes. Additionally, the payroll tax rate will likely rise from 4.2 percent to 6.2 percent after December 31st. Increased tax rates on high-income earners, stemming from Affordable Care Act taxes, are due to begin in the new year as well.

The Budget Control Act was signed by President Obama in August 2011 to end the Congressional battle over raising the government debt ceiling, in effect of this deal, automatic spending cuts are due to commence on January 2. Half of these scheduled annual cuts will come from the national defense budget and the other half will be derived from non-defense, however, 70% of mandatory spending will be exempt. Eligibility to begin receiving federal unemployment benefits will expire on December 31st; eligibility was last extended in February of this year. The rates at which Medicare pays physicians will be reduced by 30% at the year’s end also.

The debt limit sets the maximum amount of outstanding federal debt the U.S. government can incur by law and is currently capped at $16.39 trillion. Treasury is anticipated to reach this borrowing capacity in early 2013. Prolonged arguments over the debt ceiling by Republicans and Democrats could upset financial markets and raise the cost of Treasury’s borrowing.

What’s to Come?

The next several weeks leading to the new year will give Democrats and Republicans an opportunity to combine short-term measures and long-term policies to fuel the recovery and lower the debt amount. President Obama is actively trying to persuade Congress to keep tax rates low for Americans earning under $250,000. Federal Reserve Chairman, Ben Bernanke has expressed a sense of urgency in pushing for “cooperation and creativity” to devise a plan that could resolve the nation’s long-term debt budgetary issues without hindering the recovery. If no legislative agreements can be made, the impacts of the fiscal cliff can cause a drop in GDP and an increase in unemployment, leading to a recession, Bernanke remains hopeful that the new year still has a shot at bringing about recovery.