What Is the Fiscal Cliff?

by Erin C. O'Neil on 6 July 2012 3 comments
Photo: Pannawish

If you’ve been surfing the web lately, you’ve probably seen the phrase “fiscal cliff” thrown around on finance, business, and political sites.

The fiscal cliff refers to a series of fiscal policy changes set to take place at the end of 2012. While each are worrisome alone, the combination of fiscal and political changes has many concerned that the effects could snowball, resulting in a severe slowdown of the economic recovery. The November Presidential Election, which further complicates matters. Given the seeming inability of both parties to work together, it seems unlikely that either Democrats or Republicans would be willing to strike a deal on fiscal issues before the 2012 election plays out.

Still, there’s no reason to consider jumping off that fiscal cliff just yet. It’s likely that politicians will strike some sort of compromise at the eleventh hour, and that the Fed may rework the Operation Twist program given the economy’s uncertainty. But the combination of increased taxes and budget cuts could prove dire for the U.S. economy. While spending cuts would lead to a lower deficit, they could also cause the GDP to contract up to an estimated 1.3% in the first quarter of 2013, according to the Congressional Budget Office. (See also: Tax Brackets Explained)

Here’s an overview (albeit a very condensed version) of what comprises the fiscal cliff.

The Monetary Cliff

The “monetary cliff” typically refers to the end of the Federal Reserve’s “Operation Twist” program, set to complete at the end of 2012. It’s far more complicated than this, but the program essentially consists of the Federal Reserve buying treasuries from 6 to 30 years in duration to keep interest rates low. The concern is that if Operation Twist does in fact end in December of 2012, interest rates could rise, further crippling the economy.

The "Sequester" Backlash

Remember how last year the Federal budget super committee was unable to reach a deal on spending? Well, many of those postponed budget decisions could go into effect at the beginning of 2013.

The automatic spending cuts set to kick in on January 2, 2013, would cut 1.2 trillion dollars total in spending. The majority of the cuts are split between defense and domestic spending. In addition, the Federal government will reach the “debt ceiling” at the end of 2012.

Expiring Tax Breaks and More

Several tax breaks and other benefits are set to expire.

The Bush Tax Cuts

The expiration of the Bush Tax Cuts could potentially affect taxpayers across the board. This issue is sure to result in some form of gridlock; Republicans are in favor of extending all the tax cuts, while Democrats only want to extend the cuts for those making under $250,000 a year.

Emergency Unemployment Benefits End

This one is pretty self-explanatory. An end for benefits could result in the loss of unemployment income for millions of Americans, many of whom rely on it for bills and living expenses.

Payroll Holiday Tax Ends

The expiration could result in up to a 2% tax increase for workers.

Measures to Protect the Middle Class From AMT (Alternative Minimum Tax)

When these expire, middle class families will see a hike in their federal taxes.

Things get a lot more complex, but that's the general idea behind the fiscal cliff. Is this another example of fear mongering by the media, or a legitimate economic crisis waiting to happen?

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Adam

Thanks for the informative article! I wonder what effect the new healthcare law will have on government spending and the monetary cliff? I do hope that Bernanke will manipulate the interests rates to counteract whatever policy decisions are made by either party...

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bryan

Unfortunately its for real this time, too much free spending for the past 30 years has led us to this point. The economy is gong down, it wil correct and then things will get better, when the government is 14 trillion dollars in debt, you know things are bad

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Perry

Woah, 14 trillion dollars in debt is outrageously big! Never knew the American debt ballooned this big. Talking about the fiscal cliff gives me goosebumps. What would happen if the American economy goes haywire?