What is fiscal cliff?

Most experts agree that allowing the fiscal cliff to occur would lead to a substantial economic contraction and most likely a double-dip recession

The “fiscal cliff” is a term used in discussions of the US fiscal situation to describe a bundle of momentous tax increases and spending cuts that are due to take effect at the end of 2012 and early 2013. At the end of 2012 and the beginning of 2013, many major fiscal events are set to occur all at once. They include the expiration of the 2001/03/10 tax cuts, the winding down of certain jobs provisions, the activation of the $1.2 trillion across-the-board “sequester,” an immediate and steep reduction in medicare physician payments, the end of current alternative minimum tax (AMT) patches, and the need to once again raise the country’s debt ceiling.

 In February 2012, Federal Reserve Chairman Ben Bernanke coined the term “fiscal cliff”. Mr Bernanke explained, at the end of 2012, “There’s going to be a massive fiscal cliff of large spending cuts and tax increases.” Taken together, these policies would reduce 10-year deficits by over $6.8 trillion relative to realistic current policy projections—enough to put the debt on a sharp downward path but in an extremely disruptive and unwise manner.

Snapshot: Fiscal cliff

  • Some $607bn of cuts and tax rises
  • This includes reductions in the defence budget, the end of an employee tax holiday, changes to Medicare allowances and higher personal taxes
  • Lower paid to lose some child and income credits

Instead policymakers should enact a comprehensive plan to replace much of the approaching fiscal cliff with a combination of tax reform, entitlement reform, and spending reductions which could phase in gradually and thoughtfully to put the debt on a clear downward path, Mr Bernanke pointed out. The following is set to take place at the end of 2012:

Expiration of 2001/2003/2010 tax cuts

On December 31, the set of tax cuts enacted in 2001, expanded in 2003, and extended in 2010 will expire. As a result, the top rate will rise from 35% to 39.6% and other rates will rise in kind. The 10% bracket will disappear, and the child tax credit will be cut in half and no longer be refundable. Capital gains will be taxed at a top rate of 20% and dividends will be taxed as ordinary income. Finally, marriage penalties will increase, and various tax benefits for education, retirement savings, and low-income individuals will disappear.

End of AMT patches

Congress generally “patches” the AMT every year to help it keep pace with inflation. As a result, just over four million tax returns currently pay the AMT. If a new patch is not enacted retroactively for 2012, that number will increase to above 30 million for that year and would exceed 40 million by the end of the decade.

End of jobs measures

In February, the President signed an extension of a 2% payroll tax holiday and extended unemployment benefits through year’s end. Under current law, both will disappear at the end of the year, causing employee payroll taxes to increase from 4.2% to 6.2%, and reducing the number of weeks individuals can collect unemployment insurance.

End of Doc Fixes

The Sustainable Growth Rate formula calls for a substantial reduction in medicare payments to physicians. At the end of 2012, the current “doc fix” will end, leading to a nearly 30% immediate reduction in medicare physician payments.

110 billion reduction in budget

Beginning on January 1, 2013, defense spending would be immediately cut across the board by about 10%, non-defense discretionary spending will be cut by about 8%, medicare provider payments will be reduced by 2%. In total, this will result in an immediate $110 billion single-year reduction in budget authority.

Implementation of new taxes from PPACA

The Patient Protection and Affordable Care Act (PPACA) included several revenue measures set to go into effect in 2013. The largest of these measures is a 0.9% increase in the Medicare HI (hospital insurance) payroll tax for higher earners and an effective 3.8% tax increase on investment income. The law also calls for an increase in the floor for unreimbursed medical expense deduction, a 2.3% excise tax on medical devices, limits on annual contributions to Flexible Spending Accounts (FSAs), and elimination of the employer deduction for Medicare Part D retiree subsidy payments.

Debt ceiling 

In the United States, the federal government can pay for expenditures only if Congress has approved the expenditure. If the total expenditure exceeds the revenues collected there is a budget deficit, and the only way that the shortfall can be paid for is for the government, through the Department of the Treasury, to borrow the shortfall amount by the issue of debt instruments. Under federal law, the amount that the government can borrow is limited by the debt ceiling, which can only be increased with a vote by Congress. Prior to the debt ceiling crisis of 2011, the debt ceiling was last raised on February 12, 2010 to $14.294 trillion.

Reaching the debt ceiling

The debt ceiling agreement reached in 2011 is likely to allow continued borrowing through the 2012 election—particularly given that the Treasury Department has a number of “extraordinary measures” at their disposal to delay hitting the ceiling. However, the debt ceiling may need to be increased again at year’s end to avoid a potential default.

Allowing some of the policies to occur at the end of the year would not necessarily be problematic, and could indeed improve US fiscal credibility and sustainability going forward. Some broad-based changes set to occur could help lawmakers further control discretionary spending, medicare and other programs while raising new revenues if they were all implemented in a targeted and gradual way. However, allowing all of the policies to occur at once would be such a large and abrupt change that they would be economically damaging.

Policymakers should replace the dangerous fiscal cliff with a gradual, targeted, and credible plan to fix the debt, according to the Committee for a Responsible Federal Budget.

Fiscal impact of the Cliff

The changes set to occur at the end of 2012 are likely to create a large fiscal cliff if they occur all at once. Extending these policies permanently could increase the debt in 2022 by about $7.5 trillion above current law. This means debt would rise from 70% of GDP today to 88% by 2022 if lawmakers continued current policies, compared to current law where debt is scheduled to fall to 61%.

Avoiding the fiscal cliff altogether would cost about $500 billion in fiscal year 2013 and $1 trillion through FY 2014, the equivalent of nearly 4% of GDP over the relevant time periods. In other words, there would be about 4% of GDP less in deficits.

Additionally, on the tax side, the fiscal cliff would lead to abrupt increases in taxes for nearly every person. Most experts agree that allowing the fiscal cliff to occur would lead to a substantial economic contraction and most likely a double-dip recession.

Source: The Committee for a Responsible Federal Budget

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