The term "fiscal cliff" refers to a set of tax increases and spending cuts that will automatically take effect in January if Congress does not take action. On the tax side, the Bush-era cuts of 2001 and 2003, and their renewal in 2010, are scheduled to expire at the end of the year, while a number of other tax issues are in play, including an expiration of a temporary payroll tax holiday and the question of whether lawmakers will restore an elevated exemption level in the Alternative Minimum Tax. The expiration of the Bush-era cuts would increase rates on a broad measure of tax classes, including ordinary income, capital gains and dividends. Going over the fiscal cliff would increase federal tax collections by more than 20% next year, or more than $500 billion, according to the Tax Policy Center, a nonpartisan think tank. That would drive up taxes on nearly 90% of households by an average of $3,500.
The spending cuts stem from the 2011 Budget Control Act, the deal lawmakers reached to raise the borrowing limit for the federal government, which included a provision for cuts to lower the deficit by $2.1 trillion. With the failure of a bipartisan joint select committee to reach a deal on deficit reduction, $1.2 trillion in cuts would begin to take effect on Jan. 1, 2013, a prospect both parties are eager to avoid.
"The specter of harmful across-the-board cuts to defense and nondefense programs was intended to drive both sides to compromise. The sequestration itself was never intended to be implemented," the Office of Management and Budget wrote in a report outlining the impact of the cuts. "The administration strongly believes that sequestration is bad policy, and that Congress can and should take action to avoid it by passing a comprehensive and balanced deficit reduction package."
Where Are the Political Fault Lines?
On Friday, President Obama met with Republican congressional leaders for the first time since winning reelection to begin the negotiations. Leaders of both parties expressed confidence that they could reach a deal, though compromise on tax issues has been in short supply of late. Obama has held firm that taxes must increase for top earners, setting the threshold of $250,000 in household income. Congressional Republicans have signaled their willingness to negotiate on revenue increases, though it remains unclear whether they will be amenable to rate increases, as the president has proposed, or hold firm in their insistence that any increases come in the form of closing exemptions and deductions.
What's at Stake: Recession Looming?
Anxiety over the fiscal cliff has been fueled by dire projections from economists who forecast a return to recession if Congress and the White House can't reach a deal to avert the across-the-board tax increases and spending cuts. The nonpartisan Congressional Budget Office has projected that "if all of that fiscal tightening occurs," GDP will drop 0.5% in 2013, weighed down by a particularly sluggish first half of the year, before economic activity begins to revive in the third and fourth quarter. Unemployment, however, would remain a lagging indicator.
"That contraction of the economy will cause employment to decline and the unemployment rate to rise to 9.1% in the fourth quarter of 2013," the CBO projects.
But it's important to remember that economists at the CBO and elsewhere are working with a set of hypotheticals that assume that lawmakers and the president will fail to reach a deal. And their warnings, with the attendant effects on markets and business investment, are contributing to a sense of urgency that could spur policymakers to compromise, according to Neil Simon, vice president for government relations with the Investment Adviser Association, who says he is "cautiously optimistic" that Congress and the president will strike a deal to avert the fiscal cliff before year's end.
"I think the concerns about a double-dip recession are real. And I think there is very, very high awareness on Capitol Hill, and that's one of the reasons congressional leaders are likely to resolve it," Simon said "I think there's an increasing likelihood that there will be a deal before the holidays."
What's at Stake: Market Volatility?
Without a doubt, the days following the election have not been kind to the markets, as uncertainty over the government's ability to deal with the fiscal cliff have contributed to several hundred-plus point selloffs. As of Friday afternoon, the Dow Jones industrial average was down more than 600 points in the month of November.