Living on the edge: Explaining the fiscal cliff

Now that the 2012 elections are over, there’s a new political hot topic: avoiding the fiscal cliff, a term coined by Federal Reserve Chairman Ben Bernanke. Headlines tell us to be worried: “The fiscal cliff is looming,” “Grueling fiscal cliff negotiations” and “Investors nervous about fiscal cliff.” But what exactly is it, and what are its implications for the country?

In late February of this year, Bernanke used the phrase to refer to the challenges facing the US and global economies. He warned the House Financial Committee of a “massive fiscal cliff” in our future, referring to large spending cuts and tax increases scheduled for January 1, 2013 in accordance with last year’s debt ceiling deal, the Budget Control Act.

First, a bit of history. In 2001, Bush signed into law a series of tax cuts set to expire under the next president. Obama then extended those cuts and added his own, and in 2011 he and Congress agreed something needed to be done to resolve the debt ceiling crisis; hence the Budget Control Act, a bipartisan agreement that implements trillions in spending cuts and tax increases over a nine year period beginning in 2013 to reduce the now trillion dollar deficit. At the beginning of next year, if nothing’s done, the Bush-era tax cuts will expire – resulting in more than $500 billion in tax increases – and the act’s spending cuts will take effect. Many economists say that while our deficit is too high, the taxes and spending cuts would be too drastic and sudden for a slow recovering economy.

What does the fiscal cliff look like in terms of taxes? For fiscal year 2012-2013, there would be a projected 19.63% increase in taxes, most of this attributable to the expiration of the Bush- and Obama-era tax cuts. This increase amounts to almost half of the act’s expected savings. Average households would pay roughly $2,000 more in taxes next year, and those in the upper brackets would take a larger hit; put simply, the more you make, the more you’ll pay.

Although programs like Social Security and Medicaid are exempt, spending for various federal agencies and cabinet departments would also be reduced. This package of automatic spending cuts is referred to as the budget sequester (another term you’ve probably heard thrown around lately). A White House report estimates that cuts for 2013 will amount to $109 billion. Some people are concerned because lawmakers have little discretion over where and how greatly the spending is reduced – the across-the-board cuts will hit all affected programs equally.

While the economy has been steadily improving (unemployment is below eight percent, home prices are rising and consumer spending is up), some experts are saying the country could slip back into a recession if the spending cuts and tax increases are allowed to go into effect. The nonpartisan Congressional Budget Office predicts the gross domestic product – the output of goods and services produced in the US – would decrease by four percent in 2013, and the unemployment rate would increase by almost a full percentage point, which equates to a loss of almost two million jobs. In the long run, the Budget Control Act is essentially an austerity measure meant to reduce our country’s massive deficit, which most economists say is a good thing. The problem is that it does so too quickly.

Lawmakers decided years ago they wanted the act – and what is now the fiscal cliff – to force conversation about more sensible, long term deficit reduction measures. And now the CBO has projected that making a deal to avoid the fiscal cliff would improve GDP growth by an astonishing 2.9 percent by the fourth quarter of next year. However, while Republicans and Democrats agree that something needs to be done to avoid potential repercussions, they can’t agree on what that something is. Most of the debate centers on the Bush-era tax cuts that apply to household incomes of over $200,000; if they expire, the top two income tax rates would increase. Not surprisingly, Republicans want to extend these cuts, and Democrats want to let them expire.

There have been calls across party lines for a “grand bargain,” which would most likely include an extension of many of the tax cuts and a repeal of the automatic spending cuts. However a deal matters little if a timeline and framework for long term deficit reduction aren’t also agreed upon. Without an agreement, the fiscal cliff still looms.