The term “fiscal cliff” has become many things: a serious economic issue, a political football, and a cultural buzzword. Puzzling out what it actually means can be a daunting task, but a bit of research can help clarify the issue – at least a little.
In broad terms, the fiscal cliff is the combination of a series of economic and policy questions that the US government will have to face at the end of 2012. At midnight on December 31st, a number of laws will either sunset or change. These include last year’s temporary payroll tax cuts, which will result in a 2% tax increase for workers, certain tax breaks for businesses, and the 2001-2003 tax cuts. Additional taxes will increase due to the health care reform law and changes to the alternative minimum tax, while spending cuts resulting from the Budget Control Act of 2011 will take effect. According to a report by Barron’s, over 1,000 government programs – including such politically charged ones as the defense budget and Medicare – face “deep, automatic cuts.” Consumers will feel the full brunt of the changes, as the Congressional Budget Office estimates that the sudden economic retraction will lead to a recession in early 2013, delaying further economic growth until the following year.
None of these pending changes were a surprise, having developed over the last three to 10 years. The fiscal cliff came together as a result of both these converging changes in law and tax policy, and due to the inner workings of Washington D.C. itself. Partisan gridlock, stemming from differing approaches to the crisis, has largely kept Congress from taking direct action, delaying any approach to a solution. Speaking again in broad terms, Republicans have generally sought to cut spending and avoid tax hikes, while Democrats have pursued a combination of spending cuts and tax increases.
The Clock is Ticking
As the hour draws nigh, Congress faces three equally unsavory options. It may choose to let the current policy go into effect. This would risk current economic momentum and possibly drive the economy back into recession while decreasing the deficit. The Gross Domestic Product would drop by four percentage points, potentially costing the economy around 2 million jobs. As a second approach, Congress may cancel some or all of the scheduled spending cuts and tax increases, increasing both the deficit and the odds of a European-style austerity crisis. The third option is a compromise, attempting to address budget issues in a much more modest way while limiting the impact on economic growth.
What then, will happen? In all likelihood, Congress will pass a series of stop-gap measures that will delay further decision making until the new Congress takes office on January 3rd. Subsequently, the new Congress will be able to pass further legislation, even retroactively, to deal with the issues resulting from the new spending and taxation laws. While consumer confidence may be shaken by the impending changes – the phrase “fiscal cliff” certainly suggests a sudden and acute crisis – one must note that any effects on the economy will be gradual at first. Congress, bowing to political pressure, will have time to act and avert further financial shock to the American consumer.