What is the "Fiscal Cliff" and Why Should I Care?

by Michael on Nov 20, 2012 · 1 comment

Image of Falling Dollar Signs

I debated about writing this, in large part because I think the whole “fiscal cliff” thing is little more than political theater — at least in the near term.

That being said, there is so much attention being paid to it that I figured it would be worth putting together a brief synopsis of what it means and why you should/shouldn’t care.

In short, the term fiscal cliff was used back in February by Fed Chairman Ben Bernanke to refer to a combination of spending cuts and tax increases that are set to go into effect on January 1st, 2013.

Automatic spending cuts

The spending cuts are a byproduct of the inability of the Joint Select Committee on Deficit Reduction (i.e., the “super committee” — remember them?) to come to an agreement on deficit reduction back in the fall of 2011.

This committee was formed as part of the legislation (i.e., the “Budget Control Act of 2011”) that arose during the debt ceiling debacle of August 2011. They were asked to come up with a plan to reduce the deficit by $1.2 trillion over ten years, and to do so no later than November 2011.

The way the legislation was written, failure of the super committee to come to an agreement would trigger automatic spending cuts (“sequestrations”) at the start of 2013. These spending cuts, totaling an estimated $1.2 trillion over ten years (close to $110 billion per year), would fall evenly on domestic and defense spending.

The thinking here was that cuts to social programs would be so objectionable to Democrats, and cuts to military spending would be so objectionable to Republicans, that the two sides would work together to find a solution.

Unfortunately, the committee failed to find common ground, and Congress hasn’t made any progress since then. This is perhaps to be expected during an election year, but it’s still disappointing that our leadership isn’t willing to put the country’s best interests ahead of political gamesmanship.

Expiring tax breaks

As for the impending tax increases…

There are a number of existing tax breaks that will be expiring at the end of 2012. These include the Bush era tax cuts as well as the so-called “payroll tax holiday” — a temporary 2% reduction in your Social Security taxes (from 6.2% to 4.2%).

The alternative minimum tax (AMT) will also hit a bunch more taxpayers because Congress has failed to adjust it for inflation as they usually do. And there will be a new 3.8% tax on unearned (investment) income for those making more than $250k as part of the healthcare reform legislation.

A handful of other changes, including a reduction of the child tax credit, expiration of reductions in marriage penalties, and the loss of various education and other tax benefits will round things out.

All told, the tax increases are expected to total roughly $400 billion.

Effects of the fiscal cliff

So why does this all matter? What effect will it actually have if it comes to pass?

Well, the hit to the economy would be such that we’d likely sink back into recession if nothing is done. At the same time, the word “cliff” is a bit of a misnomer in that the effects wouldn’t be felt all at once.

Indeed, even if the powers-that-be haven’t made a deal by the end of the year, there would still be time to fix things before any lasting damage is done. Of course, that doesn’t mean that investor confidence would survive unscathed…

In fact, it’s quite possible that we’ll see a major selloff in the markets if Congress can’t get together on this in a timely fashion. Then again, maybe we won’t. And once a deal is struck, there will almost certainly be a rebound. Or not. 😉

In the end, it’s difficult to predict how Congress will act and how investors will react. As for us, we’re sitting tight. In the long run, this sort of drama is (imho) just a bump in the road.

Future prospects

At the outset, I referred to the fiscal cliff drama as little more than political theater in the short term. In other words, both sides will take it as an opportunity score points with their constituents while trying to make the other side look bad.

While that is almost certainly the case, there are some very real issues here in the longer term. Ultimately, we do need to get our growing national debt under control. The challenge will be to achieve deficit reduction without derailing the economy, and opinions on how best to achieve this differ widely.

Regardless — and I hope I’m wrong — I’d be willing to bet that Congress will do little more than kick the can further down the road while both sides claim victory as a result of whatever deal they strike.

Update: Congress has passed legislation (partly) addressing the fiscal cliff. They did not, however, address the spending (“sequestration”) issues, choosing instead to extend the deadline on those by 60 days.

1 Mandy November 20, 2012 at 1:00 pm

I could never be a politician. It seems in an age of self preservation, lobbyists, and harsh attack ads nothing gets done. The political theater is wearing people out, hope its over soon, you’ll get no standing ovation, or curtain call from this girl.

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