Understanding The Fiscal Cliff

Planning & Saving
on December 10, 2012

The “Fiscal Cliff” is the popular terminology used to assess the problem facing the U.S. government at the end of the 2012 (or any) year. At this time, the Budget Control Act that was ratified in 2011 is supposed to take effect.

At the stroke of midnight on December 31, 2012, the payroll tax cuts that were enacted along with tax breaks for businesses and certain other amenities are schedule to end. The effect will be felt immediately as most workers will see a 2% increase on average. Also, the health care bill that President Obama proposed will also go into effect, meaning everyone must foot the bill. Finally, the debt ceiling cuts that were agreed to in 2011 will also be implemented.

While there are options for U.S. lawmakers, most of them are not very attractive. The 3 most common views are that they can:

  1. Allow the current policy that is supposed to begin in 2013 go into effect. This features many different tax rate increases along with spending cuts in order to ward off this potential catastrophe. While on the plus side it may shrink the deficit, it will also severely cripple the Gross Domestic Product (GDP) and potentially lead to another recession.
  2. Cancel a selected number or even all of the proposed tax increases and cuts in spending, which would increase the deficit and potentially push the United States towards a crisis situation similar to what is happening in many European countries. The other issue is that the debt incurred by the U.S. will continue to add up.
  3. A middle ground could be reached, meaning a strategy that would look at the budget issues, and have a more modest impact on growth.

Is There Potential For A Compromise?

While there is always potential for the parties to agree, most investors are worried that partisanship will carry the day, meaning that the 2 sides will have a hard time agreeing on a compromise.

Potential Effects of the Fiscal Cliff

There are different effects possible if the proposed go into effect, most importantly being the impact on the economy. One the one hand, increasing taxes and reducing spending cuts will decrease the deficit by 560 billion dollars, it will also shrink the GDP by 4 percent, likely leading to a recession. Unemployment would also likely rise by almost one full point, with more than 2 million jobs expected to be lost.

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