What You Need to Know About the Fiscal Cliff

Imagine your finances are in shambles. You’re drowning in credit card debt and not making nearly enough money. So you cut your discretionary spending and get a second job to generate some more income. Most would applaud the responsible steps you are taking to fix your finances. If you are the government, however, we call it the ‘fiscal cliff.’

Fiscal CliffThe term fiscal cliff refers to a series of tax increases and spending cuts that under current law will go into effect on January 1, 2013. Given the Thelma and Louise imagery the name conjures, you might think the upcoming changes would at least solve our country’s fiscal crisis. If only that were true. Even if the law remains unchanged, our deficit next year will still exceed $600 billion, which is higher than any deficit under the Bush administration.

Anatomy of the Fiscal Cliff

Here are the main components of the Fiscal Cliff to take effect next year:

  • Expiration of the Bush tax cuts for everybody, not just those making more than $200,000;
  • Spending cuts, called sequestration, to most discretionary programs, including defense;
  • Reversion of the Alternative Minimum Tax thresholds to their 2000 tax year levels;
  • Limits on Medicare spending increases;
  • Expiration of the 2% Social Security payroll tax cut;
  • Expiration of federal unemployment benefits; and
  • New taxes imposed by Obamacare.

The impact of these changes is significant, as reflected in the following table summarizing projections made by the Congressional Budget Office:

 Fiscal CliffNo Fiscal Cliff
FY 2013 Deficit$641 billion$1.037 trillion
FY 2013 Projected Economic Growth−0.5% of GDP1.7% of GDP
Unemployment Rate in 20139.1%8.0%
Public Debt in 202258% of GDP90% of GDP

As you can see, even if we go over the Fiscal Cliff, our annual deficits will still be enormous. And that gives you an idea of just how bad things are. Here’s a chart that provides a different perspective on the same data:

Fiscal Cliff Deficit Reduction

Source: USA Today

And if you are wondering just how all these items add up, more than 50% of the deficit reduction would come from just two sources–expiration of the Bush tax cuts and the expiration of the 2% FICA payroll tax cut. The spending cuts are just a modest 10% of the deficit reduction.

Should We Fear the Fiscal Cliff?

As noted above, the CBO projects that if we go over the cliff, unemployment will rise above 9% and we’ll go into a recession. Given what we’ve been through over the last few years, the thought of another recession is a bit overwhelming. But in the long term, it may be the best option.

Some short term pain now may help us avoid much more difficult decisions down the road. And the irony is that a do-nothing government going over the fiscal cliff may be the only way to get anything done!

What do you think–Should we do a Thelma and Louise over the fiscal cliff on January 1?

Topics: Taxes

4 Responses to “What You Need to Know About the Fiscal Cliff”

  1. A deficit that’s manageable can be a catalyst for growth in the economy, but we are way beyond that. With that being said, going over the fiscal cliff will bring on austerity which sounds good on paper but hasn’t worked at all in Europe. We need a balanced, long-term approach that will reduce deficits over time (not all at once) which can provide a path to sustained growth.

  2. I think the term “cliff” exaggerates the issue. $400B in taxes/spending cuts is a big deal and I think its prudent to kick the can down the road for now. But its not a ‘cliff’ in relation to our total federal spending.

  3. I think the ‘fiscal cliff’ discussion masks the root problem – we have few drivers for sustained economic growth.

    GDP growth consists of consumer spending, government spending and ‘net’ exports. Over the past few decades, consumer spending has become a greater part of our GDP growth (~70%). And, most of that has come on the back of consumer debt. In other words, people borrowed to buy stuff they don’t need to fuel annual economic growth…and then did it every year. Without another way to drive the economy (especially in the short term), we’re in for a long period of a stagnant economy – 8-9% unemployment, slow growth, etc.

    The fiscal cliff is good discussion for media and helps lawmakers position themselves for re-election but, in reality, it has limited impact on where we will be 10 or 20 years from now. Sure, we want to address the deficit. But, even if we were out of the hole tomorrow, how do you grow the economy?

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